When you hear the word “lending,” the image that typically comes to mind is that of a term loan. You borrow from a bank, they check your credit history and cash flow, and if approved, give you a lump sum that you have to repay in regular installments over a specific period.
Asset-based lending (ABL) is a type of loan; in particular, it’s a revolving line of credit. However, unlike a term loan, asset-based lenders secure your loan through business assets, such as accounts receivables, inventory, and equipment. Rather than rely on your credit history, asset-based lenders look at the value of your business assets and treat them as a collateral for your loan. This setup is ideal for businesses with strong assets but limited cash flow.
How Asset-Based Lending Works
Asset-based lending (ABL), similar to many commercial loans, is secured by collateral. However, unlike them, ABL is typically secured against multiple asset types—not just one. It also focuses on the liquidation value of the assets instead of credit scores or profitability.
Step 1: Asset Evaluation or Collateral Assessment
The first step an asset-based lender will do is conduct an appraisal of the business assets to determine their value and liquidity. In particular, the lender wants to know the liquidation value of the assets, or what they would fetch in a forced sale scenario.
Collateral assessment is a vital step, as the type and value of the assets will determine the terms of the loan. In general, lenders prefer highly liquid assets as collateral or those assets that can be converted to cash easily or quickly should the business default on payments.
No. 1 on the list is current accounts receivables, i.e., those that are less than 90 days from invoice date or no more than 60 days past due. After that comes the rest of the business assets: inventory, machinery and equipment, real estate, and intellectual property.
Part of this process is a field examination. The lender does this to determine the level and quality of the business’ financial and physical assets. The results of this field examination along with the inventory appraisal will determine which assets are eligible to become part of the collateral and the advance rates against them.
Step 2: Borrowing Base Determination
Once the collateral has been assessed, the lender can now calculate the borrowing base. This is the maximum amount of money it will loan the business and is typically determined by the value of pledged collateral.
The borrowing base is usually a percentage of the value of the eligible assets, usually 80-90% of high-quality accounts receivables and 40-70% of raw inventory. The maximum loan amount is less than the book value of the assets because credit secured through physical assets is often perceived as riskier.
Since these assets fluctuate from time to time, the lender also adjusts the borrowing base to reflect these changes, typically each month. For instance, if in one month the business has more receivables or inventory, then it has more available credit. On the other hand, a slow season means less of these assets, so the borrowing base also goes down.
Step 3: The Funding Phase
You have passed the major hurdles of securing funds through asset-based lending. Now, it’s time to sign the agreement, which may or may not include the following covenants:
- Negative Pledge Clause
Some lenders might include a negative pledge clause or covenant as part of the loan. It limits the business from reusing the same asset for another loan.
- Cash Dominion
Cash dominion is a secured lending mechanism where a lender takes control of a business’ cash receipts to pay down outstanding revolving debt. In other words, a business’ incoming cash goes into a lender-controlled account and is first applied to the outstanding loan balance before anything else.
But, a good thing about ABL is that the business will only pay for the amount it actually uses, and cash dominion doesn’t take effect as soon as the business signs the agreement. It is often triggered by events like when a business fails to meet a liquidity threshold or when it defaults.
Step 4: Ongoing Monitoring & Reporting
Asset-based lenders want to ensure that the loan remains secured. So, they will often require the business to provide regular reports on their borrowing use and asset levels, usually on a weekly or monthly basis, to maintain their line of credit.
These reports include:
- Sales reports: As the business issues new invoices, their borrowing base grows.
- Collection reports: As customers pay the business, the funds are often directed to a “lockbox” controlled by the lender to pay down the balance.
- Inventory audits: Lenders may perform periodic physical counts to verify that the collateral still exists and is in good condition. For instance, lenders also typically conduct field examinations once or twice per year.
Key Advantages & Disadvantages of Asset-Based Lending
Asset-based lending (ABL) can be a good option, but it’s not the right option for every business in every circumstance. ABL comes with its own set of pros and cons, which each business has to weigh carefully before jumping in.
Pros of ABL
- Asset-based lending is easier to obtain than loans and business lines of credit. The only major requirement is to have assets that can be used as a collateral to secure the loan or line of credit.
- ABL puts valuable assets to good use. If the business has already invested in equipment or inventory, then it can leverage those assets to acquire additional working capital.
- ABL is more flexible than other types of financing. Asset-based lenders often impose few restrictions on business, so that as long as the funds are used for business purposes, they’re good.
- ABL costs lower than similar solutions. In comparison with invoice factoring, asset-based lending is less costly. ABL bases its interest rate on the amount borrowed, which is a percentage of the invoice or asset value. Meanwhile, invoice factoring takes a percentage fee of the invoice value, which means you’re paying more for less.
Cons of ABL
- Not all assets qualify as collateral. Assets must meet a certain criteria in order to be eligible for collateral. Typically, it has to be of high value, with low depreciation rate or high appreciation rate, and can be converted to cash easily.
- ABL costs more than a traditional loan. Because ABL needs intensive monitoring, it can incur higher management and administrative fees. Setting up an ABL facility also incurs costs, and interest rates are generally higher than banks.
- Businesses risk losing valuable assets. If a business fails to repay the loan, the asset or assets that were pledged as collateral for the loan or line of credit could be sold by the lender to recover the funds they lent the business.
Summary of Asset-Based Lending’s Pros & Cons
Main Pros & Cons of Asset-Based Lending (ABL)
| Advantages | Disadvantages |
| Easier to obtain than loans and business lines of credit Puts valuable assets to good use More flexible than other types of financing Costs lower than similar solutions | Not all assets qualify as collateral Risk of losing valuable assets Costs more than a traditional loan |
Source: U.S. Small Business Administration (SBA)
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