What is Asset-Based Lending?

Ezra Cabrera | August 19, 2022


    Key Takeaways

    • Getting a small business loan can be challenging for entrepreneurs with bad credit. This is where asset-based lending comes in: it allows you to have quick access to additional capital by putting up collateral.
    • You can use your assets to get financing solutions like short-term loans or business lines of credit.
    • Collaterals are assets you can use to secure a loan or any alternative funds. This minimizes the risks for lenders.
    • Getting asset-based loans can be a breeze for borrowers who are running the business for at least two years or those with steady cash flow. Take note that the rates and loan terms vary depending on the type of collateral you put up as well as your qualifications.

    Lenders typically ask for collateral to support small business loan applications. You're probably wondering why: new business owners who don't have cash reserves, a good credit history, or haven't been in the industry long enough have low chances of getting approved of a loan. This is where asset-based lending comes in.

    Asset-based lending means that the lender approves your loan application by submitting your physical assets as collateral. They do this to reduce their risk of not getting your payments back as agreed.

    In this article, we'll show you what asset-based lending is and how it works. We will also give you a list of assets you can use as collateral for when you decide to apply for asset-based loans.

    What is Asset Based Lending?

    Asset based lending uses collateral to secure a loan, so it's best for small businesses with many assets but may not have a strong credit history or cash flow. The assets you can use as collateral may include inventory, accounts receivable, equipment, real estate, and other valuable assets.

    Asset based lending provides quick access to capital, but it also carries higher risks for both the borrower and the lender since the lender can seize the assets if you default on the loan.

    How Does Asset-Based Lending Work?

    Small companies need a steady source of capital to ensure that their growing needs are met--from preparing payroll to keeping the lights on. However, there are instances when customers fail to pay on time or cash reserves have been temporarily used to address urgent issues like repairing equipment or paying off outstanding balances to suppliers.

    In which case, getting asset-based loans will go a long way to meeting your needs, especially when you're undercapitalized. What lenders do is advance your funds, covering up to 80 percent of your assets' value.

    Supposing you put up eligible receivables as collateral, you can receive anywhere between 70 and 80 percent of its total face value. Meanwhile, if you use your inventory as collateral, you can receive around 50 percent of your finished inventory.

    What does undercapitalization mean?

    Undercapitalization means that a company lacks sufficient capital to run its operations, pay debts, or deliver customer orders. This means that the business could not generate its desired cash flow, increasing its chances of bankruptcy.

    Types of Collateral You Can Use for Asset-Based Lending

    As a small business owner, you can use various assets as collateral. Here are the most common. 

    Most common types of collateral for asset-based lending

    1. Inventory
    2. Accounts Receivable
    3. Real Estate / Vehicles
    4. Machineries / Equipment

    1.    Inventory

    Companies in the business of manufacturing, retail or wholesale business usually have a stockpile of inventory. With asset-based lending, your lender can appraise your inventory to identify its resale value. This will be used to secure your loan.Take note that once the lender issues you your loan and fails to pay them, your lender has all the legal rights to repossess your inventory. 

    2.    Accounts Receivable

    Accounts receivables are most commonly put up as collateral by service-based companies. They invoice their customers within 30 to 90 days, so that means that it might take a while before they receive their payments for these invoices. When you use invoices as collateral, you are already applying for invoice financing.Invoice financing helps you meet your liquidity requirements so you have enough financial cushion to pay for various needs. Here's how it works: lenders will buy your invoices for up to 95% of your total invoice value. Instead of waiting around 30 to 90 days for customers to pay their invoices, lenders can already give you upfront working capital in exchange for those invoices.With invoice financing, the lender can either collect for you (invoice factoring) or you can collect your customers' payments yourself (invoice discounting). The remaining balance will be paid back to you once all invoices are paid, minus the service charges. 

    3.    Real Estate

    If you own manufacturing or retail spaces or land properties, you can use that for asset-based lending. However, this will need to be evaluated thoroughly. This often requires you to get an appraisal to determine your property's current market value.Take note that lenders will not consider the actual face value of your property unless that property is 100% yours. They will only consider the equity component of your real estate or the percentage you have paid off.Another example is your home. Some small business owners take the risk of collateralizing their homes in exchange for a loan. If you're planning to use your mortgage for asset-based lending, be sure to pay your debts, or you risk losing your home. 

    4.    Equipment

    Last but not least is your equipment. Using your machinery or equipment can be tricky to put up as collateral. Why? Because these items depreciate over time, and they might not be as valuable to the lender.However, if you're eyeing getting a small loan amount you think you can pay off anytime, using your equipment as collateral may be a great option.

    Example of Asset-Based Lending

    Let's say a small business owner sought for a loan to have access to liquid funds during the pandemic. The business is a coffee shop, serving customers for almost two years before COVID-19 changed everything.Similar businesses would be frowned upon by traditional lenders such as banks or credit unions because they are too risky to invest in. Here's why: 1) the restaurant industry is one of the most affected sectors since the pandemic hit, and 2) the business is not old enough to have a remarkable credit history.If you were the restaurant owner and no bank wanted to give you a loan, would you shut down your business? Absolutely not. There are other small business financing solutions you can choose from, like a line of credit.In hindsight, a business line of credit is a source of secure working capital for your company's short-term needs. You, as the borrower, can simply draw funds from a line of credit (usually deposited to your account). Unlike in a small business loan, a credit line won't require you to pay for interest until the money is withdrawn from the funds.Lenders usually offer alternative financing options like a line of credit to help you get the funds you need while reducing risks. However, lenders would be more comfortable lending you a line of credit when there is collateral involved to back it up. Collateral will assure them that you will pay your debts on time or risk losing your assets.At the same time, putting up collateral can help you secure larger lines of credit as well as better interest rates. You are also more likely to get approved for additional capital. That said, asset-based lending benefits you and the lender because you can increase your capital when you need it, and the lender gains security that the money you owe them will be paid as agreed.

    Is It Easy to Get an Asset-Based Loan?

    Yes and no. Getting an asset-based loan is much like applying for any type of loan, but it caters to many borrowers. Applying for asset-based loans is easy if you already have good financial statements, a steady cash flow report, or an existing pool of customers who pay their bills on time. It will also help if you have a good credit rating and if your business has been operating for at least two years.On the contrary, if your company's financial information is inaccurate and you lack the resources to prove your creditworthiness, lenders might not feel comfortable providing you a loan.

    Asset-Based Lending vs Traditional Loans: Rates

    If you want to compare asset-based loans vs traditional business loans, you have to consider various factors. In terms of costs, traditional lenders (banks for example) will often include audit, due diligence fees, and other charges before lending you the money. They might also require personal guarantees, to make sure that someone will pay off your debts in case your loan defaults. On the other hand, asset-based lenders would only charge you with processing fees or service charges, along with your collateral.In terms of interest charges, this will vary depending on your lender, the alternative funding solution you choose to get, and your business qualifications. But just to give you an overview, the asset-based lending rates can vary anywhere between seven 7% to 30%.It's best that you discuss this with your preferred lender so you know your options. However, you will generally see lower interest rates with asset-based loans compared with unsecured business loans (like a business credit card) because your assets already mitigate your lender's risks.

    Asset-Based Lending Terms

    Depending on the collateral you put up, your asset-based lending terms vary. For example, if you are going to use your business' heavy equipment to secure the loan, you can expect up to a five-year loan term. However, if you'll be using your accounts receivable, the term can be much shorter. This will depend on the terms of your outstanding invoices.

    Should You Get Asset-Based Lending?

    ant to increase your chances of getting liquid funds in the soonest possible time, then you should try getting asset-based loans. Still, it's best to talk to your lender about your situation so you can discuss your options, the risks involved, and the benefits you may get when you put up collateral.

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    About the Author

    Ezra Neiel Cabrera has a bachelor’s degree in Business Administration with a major in Entrepreneurial Marketing. Over the last 3 years, she has been writing business-centric articles to help small business owners grow and expand. Ezra mainly writes for SMB Compass, but you can find some of her work in All Business, Small Biz Daily, LaunchHouse, Marketing2Business, and Clutch, among others. When she’s not writing, you’ll find her in bed eating cookies and binge-watching Netflix.