What is Asset-Based Lending for Small Businesses?

by Corey Philip //  November 20, 2022

If you own a small business, there might be times when cash flow is a problem, or you want to expand your business but need more funds to do so. In cases like these, one option for financing is asset-based lending.

But what is asset-based lending, and how does it work?

Asset-based lending is a form of credit in which one or more of a company's assets, such as accounts receivable, inventory, equipment, and real estate, are used as collateral. The lender may seize these assets if the business cannot repay the installments anymore and defaults on the loan.

You should consider various factors to determine if asset-based lending is the right call for your small business. In the following few sections, let us look at some of these considerations and how asset-based lending works.

Let's get started.

How does Asset-Based Lending Work for Small Businesses?

Businesses usually use asset-based lending if they have cash flow issues, such as while they wait for their debtors to pay them. Companies may also use asset-based lending if they want to expand the business but need more capital and cannot secure a loan from the bank. For instance, the company may have reached its credit limit with various other credit providers.

Here's an illustration on how asset-based lending works:

A business with assets that can be used as collateral will apply for a loan from a lender willing to extend this form of credit. The collateral assets often pledged are accounts payable, equipment, real estate, and inventory. Although large corporations sometimes also use asset-based lending, it is mainly small to medium businesses that utilize this form of financing.

The company will start by identifying the asset or assets it wishes to use as collateral. The asset or assets then gets appraised, and the lender offers a percentage of its value as a loan to the business. The total value of the asset is not offered as it will enable the lender to still profit from the loan if the borrowing company defaults on the loan, thus lowering the risk.

Most lenders prefer liquid assets such as accounts receivable, though many will accept physical assets such as equipment or inventory. According to Investopedia, lenders typically offer a loan with a higher percentage of a liquid asset’s value than they would for a physical asset’s value. It is because liquid assets are considered a lower risk since they can be converted to cash more quickly.

As with a traditional loan, a loan term is agreed upon, and the business repays the lender in installments. However, suppose the company should default on the loan and be unable to repay it. In that case, the lender is allowed to seize the asset that was put up as collateral to recover its losses.

Some lenders will require a measure of control in the company to mitigate the loan risk. For instance, if a business pledges its accounts receivable, the lender might only allow the company to offer credit to clients that the lender feels can pay. More information on the different aspects, as well as examples, of asset-based lending is available on Wikipedia and Investopedia.

The Pros of Asset-Based Lending

One of the most prominent advantages of asset-based lending is that it can help businesses that cannot secure a traditional loan. For instance, companies that are still working towards getting the required credit rating. According to the U.S. Small Business Administration, the interest rates for this line of credit are often lower since the risk to the lender is not as great as with traditional loans.

Applying for and getting an asset-based loan approved takes less time than other types of loans. Therefore, it is a great way to obtain urgently needed capital. Also, according to Business News Daily, the credit limit on an asset-based loan can oscillate based on the fluctuation in the value of the business asset. An asset that appreciates can accordingly give the business more cash when needed.

According to Business Opportunities.Biz, an asset-based loan gives the business more flexibility since lenders do not prescribe what the company can use the funds for. The only condition is that the funds should be spent on the business. For instance, should an unexpected cash flow issue arise after taking the loan, the company can use the funds to remedy the problem instead.

The Cons of Asset-Based Lending

One of the most obvious cons of asset-based lending is that the business will lose the asset if it defaults on the loan. The more valuable the asset is, the greater the loss will be to the company. In addition, the loss of a high-value asset that serves a core function in generating revenue puts the business at risk of being closed down.

Although the interest rates on asset-based loans tend to be lower, Business News Daily states that the lender may charge additional fees that can increase the loan’s cost. For instance, some lenders charge additional fees if you utilize only some of the borrowed funds within a specific time frame. These fees could make asset-based lending more costly than a traditional business loan.

Since some assets, such as equipment, depreciate over time, you could have a high debt-to-asset ratio if you opt to repay the loan over a very long time. A high debt-to-asset is undesirable as the business could be closed down if it does not own enough assets to cover its debts when it has no funds to pay for them.

Some asset-based lending types can give the lender more control over your business’s funds than you may be comfortable with. For instance, some arrangements require the company to pay all its cash into an account that the lender controls. The business then has to seek approval from the lender whenever it wishes to withdraw funds.

When Should a Small Business Consider Asset-Based Lending?

First and foremost, a business can only consider an asset-based loan if it has a viable asset or assets that can be put forward as collateral. The company first needs to assess whether its assets are feasible, as there are some assets that lenders would prefer to accept as collateral.

Suppose a business is financially sound but has temporary cash flow issues or is doing well and wants to expand. In that case, an asset-based loan can be a great way to obtain the necessary funds. As stated earlier in this post, asset-based funding is also viable if you cannot secure other forms of credit. If your business is not currently financially sound, taking on a loan may be too risky.

To ensure the survival of your business, consider asset-based lending only if you are confident that you will be able to afford the installments. It is also good to consider whether the company can survive if it loses the asset.

Final Thoughts

Asset-based lending is an excellent alternative to other traditional forms of financing for a small business, especially if the company still needs to get the required credit rating as it can help resolve cash flow issues or expand the business.

Furthermore, it would be good to ensure that the company is financially sound and that the business will still be able to survive if it were to lose the asset.

(Related article: How To Minimize Cash Out Of Pocket When Buying A Business: A Practical Guide)

About the author

Corey Philip

Corey Philip is a small business owner / investor with a focus on home service businesses.

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