For companies experiencing temporary cash shortages, asset-based financing may be an alternative that makes sense as a viable way of meeting its cash shortfalls. With this method of financing, a cash-strapped business can use the assets that they have to overcome its cash flow shortages.
As noted by FinWeb, there are two primary means of asset-based financing, as follows:
1) asset-based loans
As FinWeb explains, to obtain an asset-based loan, a business must apply for a secure loan from a lending institution, collateralized by pledging one or more assets. Asset-based loans are used generally by companies with somewhat spotty credit. As such, the fees and interest rates for these loans will typically be higher than market prices. Accounts receivable and business inventory are the most common assets used as collateral, but any asset might be accepted by the lender.
Secondly, there is a method of asset-based funding known as factoring. It is often used by rapidly-growing companies in need of immediate cash. Using this process, the business will actually sell its accounts receivable to a factoring company for cash (as opposed to pledging them as collateral for an asset-based loan). For newer invoices, the company could receive up to eighty percent of their value up front. The factoring company assumes all credit risk for the outstanding accounts.
The principal disadvantage of asset-based financing is its expense. Using assets to bolster cash flow increases a business's cost of funds, thereby significantly affecting its bottom line: the profits.
REVOLVING LINES OF CREDIT (REVOLVERS)
As noted by the Journal of Accountancy, a revolver is a line of credit established by the lender for a maximum amount. The line of credit typically is secured by the company’s receivables and inventory. It is designed to maximize the availability of working capital from the company’s current asset base. The borrower grants a security interest in its receivables and inventory to the lender as collateral to secure the loan. In most cases, lenders require personal guarantees from the company’s owners.
The security interest creates a borrowing base for the loan. As receivables are collected, the money is used to pay down the loan balance. When the borrower needs additional financing, another advance is requested. The borrowing base consists of the assets that are available to collateralize a revolver. It generally consists of eligible receivables and eligible inventory.
USE OF A LOCKBOX
A typical asset based loan agreement, as observed in this analysis, gives the asset-based lender control of the company’s incoming cash receipts from customers. A “lockbox” or a “blocked account” is established by the lender for the receipt of collections of the accounts receivable. The lockbox account usually is created at the bank where the borrower does business. The company’s customers are instructed to pay their accounts by mailing remittances to the lockbox. These payments are deposited in a special account set up by the lender. The lender credits these funds against the loan balance. The lender then makes new advances against the “revolver” as requested.
A revolver differs significantly from a term loan. As discussed, the loan balance in a revolver typically is secured by receivables and inventory, which can fluctuate daily. With a term loan, the outstanding balance is fixed for a period ranging from a month to several years. A term loan has an agreed-upon repayment schedule. Generally, once an amount has been repaid in a term loan, it cannot be re-borrowed. In a revolver, however, the company can borrow, repay and re-borrow as needed over the life of the loan facility.
Entrepreneur notes that asset-based loans can be a much-needed source of capital for companies that are rapidly growing, highly leveraged, in the midst of a turnaround or undercapitalized. Sometimes a company simply needs that infusion of cash to get over a financial hump or prevent growth from stalling out.
The loans are especially well-suited for manufacturers, distributors and service companies with a leveraged balance sheet whose seasonal needs and industry cycles often hamper their cash flow.
However, asset-based loans are more expensive than traditional loans. For this reason, banks will, at times, include additional "audit" and due diligence fees to the overall cost of an asset-based loan. Furthermore, banks may not deem sales to individuals or small businesses as "eligible receivables."