Asset-Based Financing – an Alternative

For companies that find themselves with short-term cash insufficiencies, asset-based financing may be a viable way of meeting those needs. With this method of funding, rapidly-growing – and often cash-strapped – businesses can use the assets that they have to alleviate their cash flow shortages. Although there still may exist a slight stigma regarding an organization's use of its assets for hard cash, this type of financing has nonetheless proliferated in recent years, fueled in large measure by small, expanding companies in dire need of ready currency.

There are two primary means of asset-based financing: asset-based loans and factoring. To obtain an asset-based loan, a business must apply for a secure loan from a lending institution (typically a bank or commercial finance company), pledging one or more assets as collateral. As with other instruments used as loan security, the business continues to own and benefit from the assets. Only if the loan is defaulted will the lender seize the pledged items.

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, although rates have declined due to the surge in competition among lenders providing such them. Moreover, as with most commercial lending, rates can be negotiated. Lenders will evaluate the applicant company's credit history, time in business, liquidity of pledged assets, and other factors.

Accounts receivable and business inventory are the most common assets used as collateral, but any asset might be accepted by the lender. New account-receivable invoices are generally given a loan-to-value ratio of about seventy-five percent of their face amount, with the ratio dropping quickly and substantially for older accounts. For collateralized inventory, loan amounts can range from approximately thirty- to eighty percent of inventory value.

Another method of asset-based funding, known as factoring, 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). Again, 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. Once collection has been made, the business will receive back from the factoring company the remaining value, less fees and interest rates, which could run as high as fifty percent annually.

Why use asset-based financing? For small businesses, it offers several advantages, the primary benefit being quicker access to ready cash (and possibly greater amounts of it) than with more traditional loans. Asset-based lenders and factoring companies also frequently offer a number of other services that may be valuable to smaller organizations, such as accounts-receivable processing, invoicing, and collection services.

The principal disadvantage of asset-based financing is, of course, its expense. Using assets to bolster cash flow increases a business's cost of funds, thereby significantly affecting its bottom line: the profits. The business owner must weigh his or her company's situation carefully and prudently to determine if this type of funding is indeed necessary, and if it will ultimately be beneficial to the company's continued growth and overall strength.