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It’s Time to Take a Fresh Look at Asset Based Lending
by Tracy Eden Tue, 08/07/2012 - 09:06
There are many misperceptions among CFOs and finance executives when it comes to asset-based lending (ABL). The biggest is that ABL is a financing option of last resort — one that only “desperate” companies that can’t qualify for a traditional bank loan or line of credit would consider.
With the economic downturn and resulting credit crunch of the past few years, though, many companies that might have qualified for more traditional forms of bank financing in the past have instead turned to ABL. And to their surprise, many have found ABL to be a flexible and cost-effective financing tool.
What ABL Looks Like
A typical ABL scenario often looks something like this: A business has survived the recession and financial crisis by aggressively managing receivables and inventory and delaying replacement capital expenditures. Now that the economy is in recovery (albeit a weak one), it needs to rebuild working capital in order to fund new receivables 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 creditworthy,” remarks John Barrickman, the president of New Horizons Financial Group, a financial services industry consulting firm headquartered in Atlanta, Ga.
Even businesses with strong bank relationships can run afoul of loan covenants if they suffer short-term losses, sometimes forcing banks to pull the plug on credit lines or decline credit line increases. A couple of bad quarters doesn’t necessarily indicate that a business is in trouble, but sometimes bankers’ hands are tied and they’re forced to make financing decisions they might not have a few years ago, before the credit crunch changed the 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, a senior vice president with First Vancouver Finance, an asset-based lender in Vancouver, B.C.
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. Therefore, bankers pay especially close attention to the borrower’s balance sheet and income statement in order to gauge future cash flow. Asset-based lenders, on the other hand, are primarily concerned with the performance of the assets being pledged as collateral, be they machinery, inventory or accounts receivable.
So before lending, asset-based lenders will usually have machinery or equipment independently valued by an appraiser. For inventory-backed loans, they typically require regular reports on inventory levels, along with liquidation valuations of the raw and finished inventory. And for loans backed by accounts receivable, they usually perform detailed analyses of the eligibility of the collateral based on past due, concentrations and quality of the debtor base. But unlike banks, they usually do not place tenuous financial covenants on loans (e.g., a maximum debt-to-EBITDA ratio).
ABL: The Nuts and Bolts
Asset-based lending is actually an umbrella term that encompasses several different types of loans that are secured by the assets of the borrower. The two primary types of asset-based loans are factoring and accounts receivable (A/R) financing.
Factoring is the outright purchase of a business’ outstanding accounts receivable by a commercial finance company (or factor). Typically, the factor will advance the business between 70 and 90 percent of the value of the 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 1.5-3.0 percent, depending on such factors as the collection risk and how many days the funds are in use.
Under a factoring contract, the business can usually pick and choose which invoices to sell to the factor. Once it purchases an invoice, the factor manages the receivable until it is paid. “The factor will essentially become the business’ defacto credit manager and A/R department,” Klausen notes, “performing credit checks, analyzing credit reports, and mailing and documenting invoices and payments.”
A/R financing, meanwhile, is more like a traditional bank loan, but with some key differences. While bank loans may be secured by different kinds of collateral including equipment, real estate and/or the personal assets of the business owner, A/R financing is backed strictly by a pledge of the business’ outstanding accounts receivable.
Under an A/R financing arrangement, a borrowing base is established at each draw, against which the business can borrow. A collateral management fee is charged against the outstanding amount, and when funds are advanced, interest is assessed only on the amount of money actually borrowed.
According to Klausen, an invoice typically must be less than 90 days old in order to count toward the borrowing base. There are often other eligibility covenants such as cross-aged, concentration limits on any one customer, and government or international customers, depending on the lender. In some cases, the underlying business (i.e., the end customer) must be deemed creditworthy by the finance company if this customer makes up a majority of the collateral.
Stats Tell the Story
Statistics reveal that in the current credit environment, traditional bank lending overall is trending downward, while asset-based lending is trending up. According to the FDIC, the overall volume of small business loans has been shrinking 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 smallest since 1999, according to the FDIC.
On the flip side, the most recent Asset-Based Lending Index, which is published quarterly by the Commercial Finance Association, reveals that total committed asset-based credit lines were up by 1.8 percent in the first quarter of 2012 compared to the previous quarter, and total credit commitments were 7.3 percent higher than a year earlier. In addition, more than half of asset-based lenders (55 percent) reported an increase in new credit commitments.
Meanwhile, utilization of asset-based lenders’ credit lines increased to 40.8 percent in the first-quarter of 2012, which compares to 39.4 percent in the previous quarter and 39.1 percent during the same quarter in 2011.
“As we have maintained throughout the recession and credit crisis, asset-based lenders will continue to lead the way as a primary source of working and growth capital for U.S. businesses as the economy hopefully moves in a positive direction,” notes Brian Cove, the CFA’s Chief Operating Officer.
Both factoring and A/R financing are usually considered to be transitional sources of financing that can carry a business through a time when it does not qualify for traditional bank financing. After a period typically ranging from 12-24 months, companies are often able to repair their financial statements and become bankable once again.
In some industries, though, companies rely on ABL as a permanent source of financing. Trucking, apparel 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 manpower solutions to the telecommunications industry — says that asset-based lending helped get his company off the ground initially.
“When I approached my bank with a request to extend our small credit line, they said they couldn’t lend us more money based on our contracts or receivables, but only on tangible collateral like fixed assets, real estate or equipment. As a service-oriented project management company, we didn’t have this kind of collateral. We had a solid plan to grow the company, but we were facing big cash flow challenges, especially when it came to paying our growing number of employees and funding the fast growth of our projects.”
Mercado turned to an asset-based lender that provided the company with a revolving credit line based on accounts receivable that allowed them to not only keep operations going, but to implement a growth plan that has resulted in 300 percent annual growth. “Without an asset-based loan, we could not 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 growth spurts that banks are uncomfortable lending to. This is because the asset-based loan amount can increase along with the company’s inventory and receivables — or in other words, it can track the growth of the business.
Chattanooga, Tenn.-based Southeast Rubber and Safety experienced very rapid growth — between 30-50 percent a year — soon after launching, which presented the company with some significant cash flow challenges, says founder and President Wayne Guffey.
“We borrowed from everyone to start the business, invested our own money, and tapped our home equity lines of credit,” Guffey explains. Then the company was able to secure a $100,000 line of credit from its bank, which increased the credit line several times, eventually to more than a half-million dollars. But this still wasn’t enough to fund the company’s explosive growth.
Fortunately, his banker referred Guffey to an asset-based lender that set the company up on an A/R financing program that has allowed the business to continue growing at a rapid rate. “The bank wanted us to slow our rate of growth, but it’s hard for me to say ‘no’ to new business,” says Guffey. “The timing was perfect, because the A/R financing enabled us to take advantage of some opportunities we wouldn’t have been able to without it.” This included moving into a new 58,000 square-foot, state-of-the-art facility.
Stuck in the Crunch?
While ABL isn’t the right financing solution for every business credit need, it’s not a financing option of last resort, either. In the right circumstances, an asset-based loan can provide much-needed capital to help companies weather temporary cash flow shortfalls or take advantage of growth opportunities.
If your company is still stuck in the middle of the cash flow crunch, it might be worthwhile to give asset-based lending a fresh look.
About the author
Tracy Eden is the National Marketing Director for Commercial Finance Group (CFG), which has offices throughout the U.S. CFG provides creative financing solutions to small and medium-sized businesses that may not qualify for traditional financing. Further information on the company and their services offered can be found at http://www.CFGroup.net and http://www.fvf.ca. Tracy’s direct email is firstname.lastname@example.org.