There are a lot of misperceptions among CFOs and finance executives when it comes to asset-based lending (ABLs). Most importantly, ABL is a financing option of last resort, one that would only be considered by “desperate” businesses that cannot qualify for a traditional bank loan or line of credit.
However, with the economic downturn and resulting credit crunch in recent years, many businesses that might have qualified for more traditional forms of bank financing in the past have turned to ABLs instead. And to their surprise, many have found ABL to be a flexible and cost-effective financing tool.
What does ABL look like?
A typical ABL scenario often looks something like this: A business has survived the recession and financial crisis by aggressively managing accounts receivable and inventory and delaying replacement capital expenditures. Now that the economy is on the mend (albeit weak), you need to rebuild working capital to fund new accounts receivable and inventory and fill new orders.
Unfortunately, the business no longer qualifies for traditional bank loans or lines of credit due to high leverage, deteriorating collateral, and/or excessive losses. “From the bank’s perspective, the business is no longer solvent,” says John Barrickman, president of New Horizons Financial Group, an Atlanta, Georgia-based financial services industry consulting firm.
Even businesses with strong banking relationships can run afoul of loan covenants if they suffer short-term losses, sometimes forcing banks to disconnect credit lines or decline credit line increases. A couple of bad quarters doesn’t necessarily mean a company is in trouble, but sometimes bankers’ hands are tied and they’re forced to make financial decisions they might not have made a few years ago, before the credit crunch turned things around. rules.
In scenarios like this, ABL can provide much-needed cash to help businesses weather the storm. “Companies with strong accounts receivable and a solid base of creditworthy customers tend to be the best candidates for asset-based loans,” notes Tom Klausen, senior vice president at First Vancouver Finance, an asset-based lender in Vancouver, BC. .
With traditional bank loans, the banker is primarily concerned with the borrower’s projected cash flow, which will provide the funds to repay the loan. Bankers therefore pay close attention to the borrower’s balance sheet and income statement to gauge future cash flow. Asset-based lenders, on the other hand, are primarily concerned with the performance of the assets that are offered as collateral, whether they are machinery, inventory, or accounts receivable.
Therefore, before lending, asset-based lenders will generally have an appraiser value the machinery or equipment independently. For inventory-backed loans, they typically require regular reports on inventory levels, along with liquidation valuations of gross and finished inventory. And for receivables-backed loans, they typically perform detailed analyzes of collateral eligibility based on delinquencies, concentrations, and the quality of the debtor base. But unlike banks, they typically don’t put tenuous financial covenants on loans (for example, a maximum debt-to-EBITDA ratio).
ABL: the nuts and bolts
Asset-based loans are actually an umbrella term that encompasses several different types of loans that are secured by the assets of the borrower. The two main types of asset-based loans are factoring Y accounts receivable (A/R) financing.
Factoring is the direct purchase of a company’s outstanding receivables by a commercial finance (or factor) company. Typically, the factor will advance the business 70 to 90 percent of the value of the account receivable at the time of purchase; the balance, less the factoring fee, is released when the invoice is collected. The factoring fee typically ranges from 1.5 to 3.0 percent, depending on factors such as collection risk and how many days the funds are used.
Under a factoring agreement, the company can typically choose which invoices to sell to the factor. Once you purchase an invoice, the factor manages the account receivable until it is paid. “The factor will essentially become the company’s de facto credit manager and A/R department,” says Klausen, “performing credit checks, analyzing credit reports, and mailing and documenting invoices and payments.”
Meanwhile, A/R financing is more like a traditional bank loan, but with a few key differences. While bank loans may be secured by different types of collateral, including equipment, real estate, and/or personal property of the business owner, A/R financing is strictly backed by a pledge of outstanding accounts receivable from the business. business.
Under an A/R financing agreement, a loan base is established at each withdrawal, against which the business can borrow. An escrow administration fee is charged on the amount outstanding, and when funds are advanced, interest is assessed only on the amount of money actually borrowed.
According to Klausen, an invoice generally must be less than 90 days old to count toward the loan base. There are often other eligibility agreements, such as concentration limits crossed on any one client and government or international clients, depending on the lender. In some cases, the finance company must consider the underlying business (ie, the end customer) to be solvent if this customer constitutes the majority of the collateral.
Statistics tell the story
Statistics reveal that in the current credit environment, traditional bank lending is generally trending down, while asset-based lending is trending up. According to the FDIC, overall small business loan volume has been down since 2008 and was recently down 15 percent from its peak. The total number of outstanding small business loans (about 1.5 million) is the lowest since 1999, according to the FDIC.
On the other hand, the most recent Asset-Based Lending Index, which is published quarterly by the Trade Finance Association, reveals that total committed asset-based credit lines increased 1.8 percent in the first quarter of 2012 in comparison with the previous quarter. and total loan commitments were 7.3 percent higher than a year earlier. Additionally, more than half of asset-based lenders (55 percent) reported an increase in new loan commitments.
Meanwhile, utilization of asset-based lenders’ lines of credit rose to 40.8 percent in the first quarter of 2012, compared with 39.4 percent the previous quarter and 39.1 percent. percent during the same quarter of 2011.
“As we have argued through the recession and credit crunch, asset-based lenders will continue to lead the way as the primary source of working and growth capital for US businesses.” CFA Chief Operating Officer.
Transition Financing
Both factoring and A/R financing are generally considered transitional financing sources that can take a business through a time when it does not qualify for traditional bank financing. After a period of typically 12 to 24 months, companies are often able to repair their financials and return to profitability.
However, in some industries, companies rely on ABL as a permanent source of financing. Trucking, appliance manufacturing, import/export distribution, and many service industries rely heavily on factoring as their primary financing vehicle.
Gus Mercado, the founder of DataLogix Texas, a $10 million provider of workforce solutions to the telecommunications industry, says asset-based lending helped get his company off the ground initially.
“When I approached my bank with a request to extend our small line of credit, they said they couldn’t lend us any more money based on our contracts or accounts receivable, but only on tangible collateral like fixed assets, real estate, or equipment. As service “oriented to project management, we did not have this type of guarantee. We had a solid plan to grow the business, but were facing huge cash flow challenges, especially when it came to paying our growing number of employees and financing our rapidly growing projects.”
Mercado turned to an asset-based lender who provided the business with an accounts receivable-based revolving line of credit that allowed them to not only keep operations going, but also implement a growth plan that resulted in 300 percent annual growth. percent. “Without asset-based lending, we couldn’t have grown from where we started to where we are now,” says Mercado.
In addition to helping new start-ups like DataLogix Texas get off the ground, ABL is often the right financing solution for companies experiencing rapid growth that banks aren’t comfortable lending to. This is because the asset-based loan amount can increase along with the company’s inventory and accounts receivable; in other words, you can follow the growth of the business.
Southeast Rubber and Safety, based in Chattanooga, Tennessee, saw very rapid growth — 30 to 50 percent annually — shortly after launch, presenting the company with some significant cash flow challenges, says founder and President Wayne Guffey.
“We borrow from everyone to start the business, invest our own money and take advantage of our home equity lines of credit,” explains Guffey. The company was then able to secure a $100,000 credit line from its bank, which increased the credit line several times, eventually to more than half a million dollars. But this was still not enough to finance the explosive growth of the company.
Fortunately, his banker referred Guffey to an asset-based lender who put the company on an A/R financing program that has allowed the company to continue to grow at a rapid rate. “The bank wanted us to slow our growth rate, but it’s hard for me to say ‘no’ to new business,” says Guffey. “The timing was perfect, because the A/R funding allowed us to take advantage of some opportunities that we wouldn’t have been able to take without it.” This included moving to a new 58,000 square foot state-of-the-art facility.
Caught in the crisis?
While ABL is not the right financing solution for all business credit needs, it is also not a financing option of last resort. Under the right circumstances, an asset-based loan can provide much-needed capital to help businesses weather temporary cash flow shortfalls or take advantage of growth opportunities.
If your business is still stuck in the middle of a cash flow crunch, it might be worth taking a fresh look at asset-based lending.