Introduction to Asset Based Lending

In finance, asset based lending encompasses loans that are backed by some kind of asset. If the loan is not repaid the lender acquires the asset. In the broad definition of the term, asset based lending might involve lending secured by houses, cars, equipment, inventories, accounts receivable, purchase orders and many others. Even pawnshops engage in asset based lending when they allow customers to use jewelry as a way to secure a loan. In the corporate world, asset based finance involves assets normally found within a business such as accounts receivable, purchase orders, equipment and inventories. Businesses rarely use their own houses, jewelry or cars to secure a loan.

Risk Reduction and The Value of Asset Based Lending

Because they reduce risk, loans that are secured by an asset are popular with lenders. If the loan is not repaid, the secured asset is transferred to the lending organization to recoup their losses. This reduces the risk to the lender. Businesses value asset based financing because it greatly expands the volume of credit being injected into businesses. For example, many financing companies are able to offer loans secured by accounts receivable when banks are not willing to. Without these services the available business credit would be greatly reduced.

Working Capital and Asset Based Financing

In our introductory course, Finance and Working Capital Basics, we discussed the need for corrective action if current assets are too low or too high. Asset based lending is a frequently used method of correcting liquidity issues. This is especially true during periods where traditional sources of credit are hard to find. Asset based lending can be used to correct the following issues:

• The organization's current ratio is less than one and the organization has too little cash or accounts receivable.
• The organization's current ratio is much higher than 1 and has too much capital tied up in accounts receivable.

The situations discussed above can be a result of the following scenarios:

• A company experiences rapid growth and does not have the current cash flow necessary to finance an increasingly large operation.
• An organization's customers take 60 days to pay, forcing them to hold excessive amounts of receivables. This build up ties up too much of the organizations capital in short term, low return assets.
• A company may be experiencing financing difficulty and requires asset based financing in order to stabilize their business.
• Companies in seasonal industries may experience significant cash fluctuations throughout the year that.
• New businesses with expensive product that are purchase infrequently may require asset based lending to fund the fulfillment of orders.

Asset Based Lending vs Traditional Bank Lending

Factoring differs from bank lending in that it doesn't involve a loan. When banks lend, they often look at the credit of the seller and determine whether or not the seller can pay back the loan. They seek as much collateral as possible to minimize their risk.

Factoring companies are primarily interested in the credit of the buyer. They are concerned with their ability to collect from the buyer once a payment has been made. This changes to some degree if the factor makes a Non-recourse-loan versus a Recourse loan, but even in this case, their primary risk lies with the credit worthiness of the buyer.

Another key difference between factoring transactions and traditional bank lending involves interest rates. The discount rate on a factoring transaction is usually higher than what a bank would charge. However, there are many transactions that factoring companies are willing to finance that a traditional bank will not. Firms should always exhaust their sources bank capital before entering into factoring transactions.

International Business and Asset Based Finance

In countries with struggling economies and developing nations, banks are often limited in the amount of capital they have available for businesses. In these cases, banks and financial institutions can provide asset based financing solutions to these businesses in some cases. This is especially true if the borrowing company is securing the lending with a receivable or purchase order from a solid business such as Wal-mart or Target.