There are many misperceptions among CFOs and finance executives when it comes to asset-based lending (ABL). The biggest is that ABL is a financing option of last resort – one that only “desperate” companies that can’t qualify for a traditional bank loan or line of credit would consider.With the economic downturn and resulting credit crunch of the past few years, though, many companies that might have qualified for more traditional forms of bank financing in the past have instead turned to ABL. And to their surprise, many have found ABL to be a flexible and cost-effective financing tool.

What ABL Looks Like

A typical ABL scenario often looks something like this: A business has survived the recession and financial crisis by aggressively managing receivables and inventory and delaying replacement capital expenditures. Now that the economy is in recovery (albeit a weak one), it needs to rebuild working capital in order to fund new receivables and inventory and fill new orders.

Unfortunately, the business no longer qualifies for traditional bank loans or lines of credit due to high leverage, deteriorating collateral and/or excessive losses. “From the bank’s perspective, the business is no longer creditworthy,” remarks John Barrickman, the president of New Horizons Financial Group, a financial services industry consulting firm headquartered in Atlanta, Ga.

Even businesses with strong bank relationships can run afoul of loan covenants if they suffer short-term losses, sometimes forcing banks to pull the plug on credit lines or decline credit line increases. A couple of bad quarters doesn’t necessarily indicate that a business is in trouble, but sometimes bankers’ hands are tied and they’re forced to make financing decisions they might not have a few years ago, before the credit crunch changed the rules.

In scenarios like this, ABL can provide much-needed cash to help businesses weather the storm. “Companies with strong accounts receivable and a solid base of creditworthy customers tend to be the best candidates for asset-based loans,” notes Tom Klausen, a senior vice president with First Vancouver Finance, an asset-based lender in Vancouver, B.C.

With traditional bank loans, the banker is primarily concerned with the borrower’s projected cash flow, which will provide the funds to repay the loan. Therefore, bankers pay especially close attention to the borrower’s balance sheet and income statement in order to gauge future cash flow. Asset-based lenders, on the other hand, are primarily concerned with the performance of the assets being pledged as collateral, be they machinery, inventory or accounts receivable.

So before lending, asset-based lenders will usually have machinery or equipment independently valued by an appraiser. For inventory-backed loans, they typically require regular reports on inventory levels, along with liquidation valuations of the raw and finished inventory. And for loans backed by accounts receivable, they usually perform detailed analyses of the eligibility of the collateral based on past due, concentrations and quality of the debtor base. But unlike banks, they usually do not place tenuous financial covenants on loans (e.g., a maximum debt-to-EBITDA ratio).

ABL: The Nuts and Bolts

Asset-based lending is actually an umbrella term that encompasses several different types of loans that are secured by the assets of the borrower. The two primary types of asset-based loans are factoring and accounts receivable (A/R) financing.
Factoring is the outright purchase of a business’ outstanding accounts receivable by a commercial finance company (or factor). Typically, the factor will advance the business between 70 and 90 percent of the value of the receivable at the time of purchase; the balance, less the factoring fee, is released when the invoice is collected. The factoring fee typically ranges from 1.5-3.0 percent, depending on such factors as the collection risk and how many days the funds are in use.