David R. Evanson
Where’s the Money?, Winter, 1999
RESUME: ASSET BASED LOANS
Definition or Explanation: Loans, generally from commercial finance companies (as opposed to banks) which are frequently offered on a revolving basis and collateralized by a companyzzs assets, specifically accounts receivable and inventory.
Appropriate For: Companies which may be rapidly growing, highly leveraged, in the midst of a turnaround, or undercapitalized. In addition, asset based financing works only for companies with proven accounts receivable, and a demonstrated track record of turning over their inventory several times each year.
Supply: Overall, the supply of asset based financing is vast. There is a large number of commercial finance companies, as well as a number of banks, which have massive pools of capital to lend to businesses. However, for smaller asset base loans, those of $500,000 or less, the market is considerably smaller. Most asset based lenders would prefer to make larger loans because the costs to monitor an asset based loan is generally the same whether it is large or small.
Best Use: Financing rapid growth in the absence of sufficient equity capital to fund receivables and inventory. In addition, asset based loans can be used to finance acquisitions as well.
Cost: More expensive than bank financing, since asset based lenders generally have higher costs than bankers. Still pricing is competitive among asset based lenders. Small asset based loans can get pricey though, running between 12% and 28%.
Ease of Acquisition: Comparatively easy if your company has good financial statements, good reporting systems, inventory that is not exotic and finally, customers who have a track record of paying their bills. If you do not have any of these things, your path to an asset based loan will be challenging.
Range of Funds Typically Available: $100,000 and up
ASSET BASED LENDING – WHAT IS IT?
Conceptually, asset based loans are easy to understand, according to William Barnett, a partner with law firm of Herrick, Feinstein, New York City, who specializes in asset based lending. Specifically, he says, “Asset based lending is formula lending based on the liquidation value of accounts receivable and inventory.”
While term lenders certainly consider the value of these assets when making a loan, they are secondary. For the most part, when a banker makes a term loan, he or she is looking at the cash flow [italicize cash flow] of the enterprise, and trying to determine whether or not it is sufficient to service the debt, and whether or not it can be sustained for the term of the loan.
Asset based lenders on the other hand, do not focus on this. They look at two asset classes: accounts receivable and inventory. With a knowledge of these assets, the asset based lender will make a short term loan. Although this short term loan gets paid off as accounts receivable and inventory liquidate, for growing businesses, more accounts receivable and more inventory are being created all the time. As a result, an asset based loan has a revolving quality to it, and may remain on a companyzzs books for quite some time. This can be a a good thing, because it gives a company time to catch its breath. But is can also work against a company because, an asset based loan can may not get renewed, and must then be paid back before a company is prepared to do so.
An asset based lenderzzs emphasis on assets rather than cash flows makes a significant impact on the relationship between lender and borrower according to Barnett. First, the asset based lender is taking a security position in the underlying assets, and views liquidation of them as a viable means of recovering the loan principal. Second, because the asset based lender is lending against assets which can fluctuate in value rapidly, he or he will monitor these assets more intensively. “Itzzs not uncommon,” says Barnnett, “for asset based lenders to look at the inventory or accounts receivable once a month, sometime even more frequently.” Conventional lenders making term loans on the other hand, might review financial data once a quarter, and never look at inventory once the initial loan is made.
SIDEBAR: THE FACTOR FACTOR
A close relative of asset based financing is factoring. The primary difference between asset based lending and factoring is that the former is a loan against an asset, while the latter is the outright sale [italicize sale] of an asset. Thatzzs right, when you factor your accounts receivable, you sell to a third party your right to receive payment. Of course if you sell the asset you receive payment, just not as much as you would receive if you waited until your customer maker their payment. A factor makes money by purchasing your $100 receivable for $87.50 and then receiving from your customer the full payment of $100.
One of the drawbacks of factoring is that once you sell your accounts receivable, you lose control over how they are collected. A factor which collects very aggressively, might turn off your customers and damage the relationship you have built up with them.
Shop Talk: When a lender takes a zzsecurity interestzz in an asset it means they are granted possession of and ownership in the assets in the event of a default. The security interest which lenders are able to take on inventory and accounts receivable is the basis of their collateral, and as a result the underpinning of the loan.
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ESTIMATING YOUR BORROWING CAPACITY
Your borrowing capacity for an asset based loan rests on what your assets will support, and not unrelated, the maximum line a lender is willing to grant you.
Barnett says that most asset based lenders will lend 90% of “eligible” receivables, and 50% of “eligible” inventory. So, whatzzs meant by the word eligible?
Basically, just because you have an asset on the books doesnzzt necessarily mean that a lender will advance you funds against it. “Asset based lenders will deduct ineligible receivables such as those from mom and pop shops, or ones that are more than 45 days old, or ones from customers that have had a bad debt on prior receivables, or perhaps receivables due from customers overseas.”
So on the receivables side the equation looks like this:
Total Receivables – Ineligible Receivables = Net Eligible Receivables.
Net Eligible Receivables x 0.90 = Total Borrowing Capacity From Receivables
The same concepts apply to inventory. That is, the inventory on hand needs to be adjusted by the lender. Specifically, ineligible components must be removed to estimate what constitutes the eligible portion. Ineligible inventory might include items that are over 180 days old, certain exotic goods which would be difficult to liquidate, and material that may have spoiled or been damaged.
Total Inventory – Ineligible Inventory = Net Eligible Inventory.
Net Eligible Inventory x 0.50 = Total Borrowing Capacity From Inventory.
Barnett says that adding the two sums together, and subtracting out any outstanding debt represents the total availability of what can be borrowed, as long as it does not exceed the total line available to the company which is spelled out in the agreement between the company and the borrower.
Why does inventory get such a low advance rate, just 50% of eligible inventory, while accounts receivable gets 90% of the eligible amount? Basically, says Timothy Gannon, senior vice president and chief lending officer of MTB Bank, a privately held New York City-based bank specializing domestically on asset based loans, “the accounts receivable are self liquidating, while the inventory is not. If a lender needs to liquidate in order to recover the loan, they will have to take possession of the inventory and sell it, which can be difficult, time consuming and expensive.” By contrast, he says, the majority of accounts receivable will, over time, hopefully 30 days of time, turn themselves into cash through payments from customers.
ASSET BASED LOANS – HOW THEY WORK
The diagram below shows the cash flows of a typical asset based loan.
FLOWCHART FOR AN ASSET-BASED LOAN
Step 1. The process starts with the company selling its product or service to customers. Unless itzzs a cash business, or a business where customers pay for all of their purchases by credit card, a receivable is created. The receivable, really a debt to the company, will in most cases be repaid to the company in 10, 15, 30 or perhaps 45 days. This asset, in combination with inventory, which is not shown in the above diagram, starts the process.
SIDEBAR: VENDOR FINANCING
Slightly further up, or further down the food chain, depending on your perspective, is another source of asset based financing. Vendors. In fact, vendors already do offer financing by giving most of their customers 30 days to pay their invoices. The reason many businesses need asset based financing to begin with is that their sales cycle is longer than their accounts payable cycle. After all if you could purchase goods on 30 day terms, sell them and get paid within 15, who needs financing? Unfortunately, most sales cycles take longer.
So before talking to a commercial finance company start with your vendors. There are two ways to do this. The first is simply not to pay their invoices until they are 90 days old. This gives you three months of financing, in some cases free. Youzzll know this strategy is working if they donzzt freeze shipments to you after your first invoice is over 60 days old. The second way is to simply ask your supplier if they will extend your payment terms. If this is offered in conjunction with a lien of the materials they sell you, the vendor might just bite. After all, even if they donzzt have the cash from you, they have still booked the sale. If your vendor is under pressure to show sales growth quarter to quarter, or year to year, your sale, even if it takes 90 days to collect, is helpful to their cause.
Another way to get a couple of extra days out of your vendor is to test their limits. For instance if you pay your invoices on 30 days, pay them at 35 days for a few months. If theirzzs no complaint, then stretch them to 44 days. Why does this work? Because many accounts receivable collection systems flag payments that are older than 45 days. Therefore if 35 days isnzzt a problem, then chances are, 45 days is the magic number you need to avoid in order to keep the vendor happy.
Donzzt Forget: Lenders want accounts receivable and inventory that can be turned into cash quickly. If you deal in exotic stuff, with exotic customers, which cannot be easily sold, asset based lending may not be for you.
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Step 2. The lender makes a loan to the company based upon the value of the receivable. As discussed above, the lender will not advance 100% of the of the receivables, but 90% of the eligible receivables. The moment that the funds are advanced, the company starts paying interest, and the lender starts earning interest.
Step 3. Pay close attention here. Note that with an asset based loan, in most cases, the customers do not send their payments to the company who sold them the product or service, but instead directly to the finance company. Asset based lending can be uncomfortable for some companies because a third party gains control of their cash flow.
This discomfort is warranted. Under such a scenario, certain events may turn out badly for the borrower. For instance, suppose a borrower has a large outstanding balance that is continuously revolving. Further suppose than an entire group of the borrowerzzs customers experienced some sort of financial peril. Say they all sold products to a region of the world which experienced financial meltdown. The lender, who monitors the assets very closely, and can begin to see the length of these customerszz receivables expanding, may take a “reserve” to protect itself against possible loan losses. Where might this reserve come from? From the companyzzs customer payments of course. Instead of remitting customer payments to the company, the lender will hand on to some of them to create this reserve against future loan losses. Suddenly, the company does not have funds which it may have been counting on.
Step 4. The lender remits to the company invoices paid, less the principal on loans it has already advanced, less interest.
A Good Deal: You cannot look at the cost of asset based loans — which can carry annual interest rates of 24%, or more — in absolute terms. It appears far too expensive. Most experts counsel that smart borrowers treat the cost of an asset based loan like another cost of doing business. If the loanzzs expensive, but you can stay in business and make a profit, then thatzzs what you need to do.
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REQUIREMENTS AND SCENARIOS
MTBzzs Gannon says that in order to successfully negotiate an asset based deal, borrowers will need to come to the table with financial information that paints a positive picture and is also detailed an accurate, as well as a willingness to make the lender comfortable. Among the requirements he cites:
• The business must have a reasonable net worth, and long term viability.
• Financial statements must be reviewed by a certified public accountant whom the lender deems acceptable.
• Borrowers must submit a yearzzs worth of monthly projections.
• The principals of the business must guarantee the loan, and the guarantee needs to be supported by personal financial statements.
• Keyman (or keywoman) life insurance may be required.
But Gannon says that even if you qualify for an asset based loan, it might not be the way to go. “Asset based loans are more expensive than bank lines of credit, and are often much more intrusive on the borrower.
For instance, he says if you have a good guarantee, are profitable, and need to borrow say $500,000 twice a year for 60 days, go to a commercial bank. “Thatzzs the cheapest, easiest way to go.”
Similarly, if you have a good guarantee, and need a line of credit to support inventory and receivables that can be “cleaned-up” (i.e. paid back) within one year, therezzs a good chance a bank will take a security interest in your inventory and receivables and offer a line of credit or a revolving line of credit. “This also will be cheaper than traditional asset based loans.”
But he says, “If your guarantee is not that strong, you are not that profitable, your business is undercapitalized, you need working capital and there is no way you can pay off a line for perhaps two or three years,” says Gannon, “you present a problem for most banks even if despite the above circumstances, your business is a good one.” He says that the bank may take a flyer, but that in most instances such as this, a bank would refer you to a commercial finance company offering asset based financing and and that a commercial finance company will be your only source of salvation.
Taking Action: Looking for an asset based lender? One of the fastest and easiest ways to start your search is to visit the Web site for the Commercial Finance Association. You can enter the amount and type of capital you are looking, and the site will give you the name, telephone number and a contact persons at all the commercial finance companies that match your initial criteria. Visit www.cfa.com.
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