What is asset-based lending & how does it work?

It’s no secret that small and medium-sized businesses (SMBs) often face financial challenges.

While loans are a common solution, many companies lack the creditworthiness for conventional loans. 

This is where asset-based financing usually comes into play. This type of financing allows businesses to use existing assets such as inventory, equipment, or receivables as collateral to gain quick access to credit. 

It can certainly help manage cashflow and support growth, but it’s important to understand the details to make sure it’s the right fit.

This article explains what asset-based lending is, how it works with practical examples, and its pros and cons.

What is asset-based financing?

Asset-based lending (ABL), or asset-based finance, is a form of lending where a company uses an asset as collateral. This can be receivables, inventory, real estate, or company equipment.

As this guarantee reduces the lender’s risk of default, SMBs have a better chance of qualifying for this type of loan compared to other options.

If the borrower defaults on its obligations, the lender can seize and sell the collateral to cover its losses.

ABL is primarily used by businesses rather than consumers - and is particularly beneficial for small and medium-sized companies that need to cover short-term cashflow needs. Or to invest in growth opportunities.

Key points for asset-based financing

Asset-based loans are a popular way to cover short-term expenses and stimulate business growth. Many SMBs face cashflow and liquidity challenges and need working capital to keep operations going.

That’s why, in 2019, approximately 43% of small businesses applied for a loan, according to the Federal Reserve Report. 

On the other hand, they may not have the creditworthiness or the means to obtain a traditional bank loan.

That’s why assets as collateral are an option for these companies.

However, lenders need to protect themselves in the event of a default. This means that they may offer a lower loan amount than the value of the pledged assets to protect their interests in case the borrower fails to repay.

Discover 5 tips for securing the capital you need to scale your business and learn to navigate the complexities of funding.

How does asset-based lending work?

This kind of lending allows businesses to secure loans using their assets as collateral.

If a company cannot demonstrate sufficient cashflow or credit history to qualify for an unsecured loan, lenders may approve it by using business resources as a guarantee.

The loan amount depends on the nature and value of these assets. This means that the value of the collateral, rather than the borrower’s credit rating or cashflow, is the primary factor considered when granting the loan.

Some lenders prefer tangible assets that can be easily converted into cash if the borrower defaults. In this case, the lender can seize and sell the assets to recoup the losses.

For a more comprehensive understanding of how asset-based financing operates, consider this example:

TechGear Solutions, a SMB crafting cutting-edge gadgets, seeks an asset-based loan. Their state-of-the-art machinery inventory and recent sales receivables may serve as the collateral. Recognizing the worth of these assets, the lender promptly unlocks capital with mutually agreed repayment terms.

From this point, two potential outcomes may come up:

1. Successful repayment: TechGear Solutions adheres to the payment schedule, utilizing the loan to amplify production and sales. The agreement concludes without any lingering commitments, allowing the business to thrive.
2. Default: in the event that TechGear Solutions fails to meet the payment obligations, the lender assumes ownership of the pledged machinery and receivables to offset its losses. This safeguards the creditor’s interests, while TechGear Solutions must grapple with the repercussions of the default. 

Asset-based financing in a practical example 

Let’s take a closer look at TechGear Solutions’ situation as an asset-based finance example so you can better understand how the process works. 

The company needs $12,000 to cover manufacturing costs and offers payment terms of up to 120 days to its overseas buyers.

To secure this financing, the SMB applies for an asset-based loan from a financial services provider.

The lender agrees to finance 90% of the requested amount, i.e. $10,800, by securing the loan against TechGear Solutions’ assets.

The loan is secured by SMB’s $12,000 worth equipment. The agreement provides that the lender will take title to the equipment if TechGear Solutions fails to meet the repayment terms.

Fortunately, TechGear Solutions receives timely payments from its overseas customers and repays the loan in full and on time to the lender.

The agreement is entered into with no long-term commitments or repayment terms.

Key asset-based lending advantages 

Asset-based financing offers several potential benefits to small and medium-sized businesses.

Here's an overview of the main ones:

• Access to working capital: loans can provide quick access to funds to cover short-term business expenses.
• Availability for different business sizes: this financing option is accessible to companies of different sizes and it’s not limited to large corporations.
• Alternative to traditional loans: businesses that have reached their traditional credit limits can still qualify for asset-based finance.
• Potential for improved cashflow: loan capital can help stabilize cashflow, which can support business operations and growth initiatives.
• Complementary financing option: asset-based loans can often be used alongside other forms of financing.
• Flexible loan structures: these loans can be structured as lump sum payments or lines of credit, depending on the business's needs.
• Fewer restrictions on use: generally, there are fewer limitations on how the capital can be used compared to some other loan types.
• Structured repayment terms: lenders usually offer fixed repayment plans, which can help with financial planning and budgeting.
• Diverse collateral: businesses can use a variety of assets as collateral, including both liquid and tangible assets.

Understanding the disadvantages of asset-based financing

Even though asset-based lending can offer benefits, you should be aware of the potential risks:

• Collateral risk: if a company fails to repay the loan, the lender can seize the assets used as collateral.
• Impact on credit rating: missed or late payments can have a negative impact on the business's credit rating.
• Future borrowing challenges: if a company fails to repay the loan, it may become more difficult to obtain financing in the future.
• Ongoing monitoring: lenders may require regular audits or reports on the assets used as collateral, which can be time-consuming.
• Potential over-indebtedness: easy access to capital based on assets could tempt some businesses to take on more debt than they handle.

It's worth noting that some forms of asset-based loan may be less risky than others.

For example, invoice financing (where businesses borrow against unpaid invoices) usually involves lending against the company’s existing receivables. 

How does your business qualify for asset-based financing?

To determine whether a business qualifies for an asset-based loan, lenders look at various factors to ensure it meets their criteria.

These include, for example, high-quality collateral, ideally assets with low depreciation rates that can be quickly converted into cash. A solid credit and financial history are also conducive to lending. 

However, specific requirements may vary depending on the loan product and lender.

Here’s what creditors typically look for:

• Financial history: lenders review a company's financial history as part of their due diligence process.
• Loan amount: the value of the business’ assets must cover the loan amount, plus a premium to compensate the lender for converting the assets into liquid capital.
• Type of assets: lenders assess the value and liquidity of the assets you offer as collateral. Liquid assets are often preferred over tangible assets as they’re easier to convert into cash.  

Are you ready to unlock your business potential?

Now that you know the ins and outs of asset-based loans, it's time to put that knowledge into action.

At Stenn, we've taken the best aspects of asset-based financing and refined them into our specialty: invoice financing. 

Asset-based finance offers numerous benefits, from improved cashflow to flexible loan structures. Our invoice financing takes these benefits one step further:

• Lower risk: unlike conventional loans, you only borrow money that is already owed to you.
• Preserve other assets: keep your equipment and inventory free while you convert your receivables into immediate capital.
• Simplified process: no complicated asset valuation – just straightforward financing based on your outstanding invoices.

You have the assets. We have the expertise. Let's make your invoices work harder for you.

Whether you're looking to stabilize your cashflow, cover short-term expenses, or invest in new opportunities, our tailor-made solutions give you the edge you need.

‍Talk to our team and discover how we can support your growth today.