Since it’s unlikely for lenders to always accurately predict that borrowers will default on their loans or not, several lenders have come up with different methods of limiting the risks on the loans they provide.
One of such methods is Asset based lending. So what exactly does it mean and how does it work?
Let’s get started.
Asset based lending is the method of offering loans to borrowers based on a mutual agreement that the fund is protected by collateral. This means the borrower offers a valuable item as collateral in order to get the loan.
Some of the acceptable collateral in asset based lending are property inventory, equipment, accounts receivable as well as other items the borrower owns and is willing to offer as collateral.
Unlike several other types of loans, the asset based lending sector provides loans to businesses and not individual consumers. This is why it is otherwise referred to as commercial finance or asset-based financing.
The interest rates that are requested on asset based loans are not as high as the ones on unsecured loans.
This is so because the lender has the benefit of recovering most or all of its losses if the borrower failed to repay the loan.
Nonetheless, the interest rates lenders charge is often absolutely different and this is based on the borrower’s credit history, how long he or she has been in business and his or her cash flow.
Asset Based Lending: How The Process Works
Several businesses rely on loans or lines of credit to sustain their regular cash flow needs. For instance, a business could get a line of credit to sustain its payroll costs even in the event of a short setback in payment it anticipate to get.
If the business looking to get the loan is unable to show sufficient cash flow or cash assets to secure a loan, the lender may decide to authorize the loan using a valuable physical assets as collateral.
For instance, a new startup may only be eligible for a loan by offering its tools as collateral.
However, the type and worth of items provided as collateral often determine the terms and conditions of an asset based loan.
Many lenders prefer collaterals that are easily transform into cash if the borrower failed to repay the loan within the specified time as agreed.
When lenders give out loans where the borrower offers physical assets as collateral, they are viewed as riskier. As a result, the maximum loan will be significantly lower than the actual assets value.
Here’s an example of asset based lending
For instance, if a business needs a $500,000 loan to break into new markets and the company offers its marketable securities that can be easily converted into cash on its balance sheet as security, the lender may decide to give a loan that equals 85% of the face value of the collateral.
So if the company’s collateral is valued at $500,000, the lender will be ready to offer a loan of $470, 000.
However, if the company offers an asset that’s not so easy to convert into cash, the lender may only be willing to provide half of the entire loan.
In either situation, the discount reflects the expenses of converting the collateral into liquid cash and its possible loss in market value.
What Type Of Companies Obtain Asset Based Lending?
Most of the companies that obtain asset-based loans are small and mid-sized. The eligible ones among these type of business are the ones that are financially stable and have valuable physical assets.
Nonetheless, some large firms sometimes apply for asset-based loans to take care of short-term costs.
The amount required and long lead period of offering more shares or bonds in the capital market could turn out to be too high.
Also, the cash requirement could be very time-delicate like in the situation of a key acquisition or buying a required equipment suddenly.
Important Things to Note:
- Asset-based lending involves giving out loans to borrowers who offer valuable assets as collateral.
- Lenders in this industry prefer collateral that can be easily converted into cash better than physical assets such as tools or equipment.
- Most of the businesses that opt for asset-based loans are small and mid-sized that needs to regularly secure short-term cash flow needs.
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