Asset Based LendingExplained, Advantages & Disadvantages, and Examples
What is Asset-Based Lending?
Asset-based lending is referred to as a secured type of lending or collateral-based lending.
In this type of lending, collateral is required.
Typically, it is a valuable asset that serves as security if the borrower fails to repay the loaned amount.
Asset based-lending is only being offered to business enterprises.
Collaterals can be in the form of receivables, inventories, equipment, or other properties a firm owns.
How Asset-Based Lending Works
There are many reasons why a firm needs additional funds.
Some may need to expand the current operations of the business, product improvement, additional working capital requirements, payment of short-term liabilities, etc.
For example, if the business is suffering from a delay in receiving its receivables and an urgent product revision needs to be done, the enterprise then may apply for a loan and pledge one of its assets or the receivables as collateral should their cash flows or cash assets not be enough to support their application for financing.
One of the primary requirements in asset-based lending is the presence of highly liquid assets such as marketable securities or money market instruments so that they can be easily converted to cash when the borrower defaults on the loan payments.
However, physical assets may be used such as land, real properties, or machinery and equipment but they are considered riskier.
The amount of loan and repayment terms granted will depend on the relative value of the collateral and the interest rate will also depend on factors such as the credit history of the firm and its cash flow, and the period of doing business.
For example, a company has applied for a $100,000 loan to be used for product improvement and used its money market instruments as collateral.
The money market instrument is considered a very liquid asset and the lender agrees to lend an amount equivalent to 85% of the face value which is $100,000.
However, if the firm can only provide physical assets as collateral, the lender will only be able to extend a loan equivalent to 50% of the required loan amount.
The discount rate used in both scenarios represents the cost of the conversion of assets to cash.
Small and Medium Enterprises are the most common firms that require asset-based financing although large corporations also enter into asset-based lending to address short-term financial needs that are urgent.
Time-sensitive acquisitions or requirements will force large corporations to prefer asset-based financing due to the high cost of issuing additional shares of stocks or bonds.