Entrepreneurs have two options when seeking out business loans. One option is an unsecured loan, and the other option is asset-based business financing. Asset based business loans are diverse as well, with financing available for numerous asset types.
Let’s take a look at what choices a business owner has when it comes to asset-based or secured loans.
How Does Asset Based Financing Work?
The collateral is a central concept in asset based business loan. Your loan is secured or guaranteed by the value of the assets you pledge as collateral. Lenders will assess the value of your assets and come up with a loan-to-value ratio. The LTV ratio is a percentage of the total value of your assets that the lender is willing to let you borrow.
For instance, you have equipment that you’d like to pledge as collateral for financing. They have an aggregate value of $500,000. The lender inspects your assets and decides on an LTV ratio of 80%. This means that you can borrow a maximum of $400,000. 80% is a good LTV ratio, but some lenders could go as low as 60%.
Pros and Cons of Asset Based Business Loans
Secured financing has its own set of advantages and drawbacks for the business owner. One advantage of asset-based financing is that lenders can offer higher amounts for the loan. Approval is speedy too. You can have your money within minutes of applying for financing. Cash is vital for maintaining your working capital, and a quick approval process is certainly a plus.
Secured loans also generally offer comfortable repayment terms. Some loans could go as long as 30 years, or at least 10 years. This gives your business the benefit of keeping up with the obligation without breaking your cash flow.
You need not worry about business or personal credit scores with secured financing. Lenders are likely to consider your assets’ liquidity and value more than your credit ratings. With collateral, you lessen their risk exposure by securing the loan with your assets. More liquid assets, or those that can be easily converted to cash, lessen the risk exposure further and increase your chances of approval.
There are, however, risks that entrepreneurs could face when using their assets as collateral for their loans. Lenders are comfortable extending secured loans to businessmen because they can repossess your assets if you default.
In other words, you could end up losing those assets if you are unable to repay your loan. The lender will seize and auction your assets to recover from their losses. There are lenders, however, who are willing to help their troubled clients. These creditors would rather focus on collecting the loan than going through the process of an auction.
Lenders also report your payments to the appropriate business credit bureaus. You are at risk of a reduced credit score if you default on the loan. You run the risk of limiting your access to more financing with a lowered credit score. However, proper cash flow management is key to mitigating that risk to your business.
What Are The Different Kinds of Asset-Based Loans?
As mentioned earlier, entrepreneurs have numerous choices for asset based based business loans. Each loan accepts a specific type of asset as collateral. Each type also has its own set of features for the business owner to consider.
This loan covers your expenses for acquiring new equipment for your business. The lenders consider as collateral the new hardware that you will be purchasing using the loan. This type of secured loan is unique because it awards you the full value of the equipment that you want to buy instead of a percentage.
The process is very simple. You apply for equipment financing through a lender’s website. You upload the requisite documents and wait for the lender’s customer representative to give you a call. The agent will interview you about your business and what utilities you’re planning to buy. The agent will call you again if you have been approved for a loan to discuss repayment terms.
The lender will then require you to send them a vendor’s invoice for the equipment. The company will pay the vendor directly using your invoice and notify you that your hardware is ready for pick up.
You can use the equipment right away to generate revenues for your business. However, the lender continues to have a claim over the gear as long as the loan is not fully repaid. The lender will repossess and resell your machinery if you are unable to keep up with payments.
Invoice Financing and Factoring
Invoice financing and factoring are two types of asset based business loans that are secured by your pending invoices. This is ideal for businesses that provide their customers with inventory on terms instead of cash basis. This loan provides cash equal to a certain percentage of your invoices’ total values.
Invoice factoring involves turning over your accounts receivables to the lender, who assumes the responsibility of collecting on those debts. You also receive a percentage of the invoices’ value as a cash advance minus a service fee. The lender will contact your debtors and collect a payment within 90 days. You will receive the remaining value of the invoices once the collection is complete.
On the other hand, invoice financing is purely a loan that’s secured by your invoices. The lender will assess your invoices’ loan-to-value ratio, and wire the money to you. Collection of your pending invoices remains your responsibility, and you’re expected to repay the loan as agreed.
You can use cash from invoice factoring and invoice financing for various purposes. You can pay your employees’ salaries, perform a vital repair in your commercial property, or add to your working capital.
Merchant Cash Advances
Merchant cash advances are best for businesses that allow credit card payments aside from cash. Lenders will provide you a loan based on the average amount of credit card payments you’ve processed before applying. You will then repay the lender by forwarding a specific percentage of your future credit card sales.
One benefit of merchant cash advances is flexibility. You don’t have to worry about specific payment terms every month. The lender will only take a fraction of your credit card sales in the preceding months until the loan is fully repaid.
However, merchant cash advances can become expensive in the long run. You’d also be stretching the repayment terms and the interest rates if your business experiences slow months of sales. These advances are only good for short-term cash flow needs but not for long-term financing.
Merchant cash advances are also limited to any business that processes credit cards. If your business limits itself to cash transactions, you’re instantly ineligible for this advance.
Inventory financing is great for businesses that deal with significant movements in inventory, like retail stores. Entrepreneurs can apply for an advance from a lender based on the assessed value of the inventory. You receive a percentage of that total value as a loan, with amounts determined by the loan-to-value ratio.
Small businesses that expect a big inventory movement and would like to stock the shelves in advance can take advantage of inventory financing. Retail stores, for instance, can borrow money against future sales ahead of events like Black Friday and Christmas Day. The cash will prevent inventory shortage and unrealized revenues.
However, not all types of businesses can receive a high loan-to-value ratio. Lenders are very particular with the quality of inventory pledged as collateral. For instance, raw materials can fetch a higher loan-to-value ratio because of the variety of their applications. For lenders, this means that the inventory can be quickly liquidated. The revenues will aid the borrower in repaying the terms of the loan and lessen the risk of default.
On the other hand, lenders generally provide lower LTV ratios to finished products like jewelry and electronic gadgets. They are less liquid and would take time to be converted into cash.
Lenders also consider other factors such as inventory turnover ratio, the business’ profitability, cash flow, and any tax lien history. Lenders may also look at the diversity of the retail store’s customer base as well.
Every entrepreneur must take time to understand what his options are in terms of financing. Financing is more advantageous than paying cash because it does not break your cash flow. You can stretch your cash reserves with these loans as well. However, you can only take full advantage of financing if you know what type of loan is best for a given situation.
If you’re expecting huge sales shortly, you can use inventory financing to replenish your stocks and prepare your business for the coming revenues. On the other hand, you can invoice factoring or invoice financing to receive cash ahead of your accounts receivables. You could also take out equipment financing to purchase new equipment to add to your assets or to replace obsolete ones.
Each of these loans has its own set of advantages and disadvantages as well. You should also be knowledgeable about this as an entrepreneur. Knowledge is important to avoid making the wrong decision when finally seeking financing for your business.
Financing can also affect your cash flow. You’ll want to make the most advantageous choice, and only a thorough knowledge of each option makes that possible.