“An old stereotype is that asset-based loans are for companies that are distressed,” says Bruce Guest, senior vice president and division manager for asset-based lending at FirstMerit Bank.
Asset-based loans are an excellent fit for business owners in promising turnaround situations, as well as manufacturing concerns and companies experiencing fast-paced growth. Seasonal businesses and companies going through ownership transition also benefit from this type of loan. Many business owners appreciate the asset-based reporting structure, using it as a “tool” to ensure they are matching their borrowing level to the growth level of their business.
Guest explained why asset-based loans are a solution for any company at any stage in their business life cycle to Smart Business.
How does an asset-based loan work?
Rather than basing a loan off a company’s cash flow and overall balance sheet leverage, as in a traditional secured line of credit or term loan, the asset-based lender lends a percentage against the company’s working capital assets. This typically includes accounts receivable and inventory. As the business experiences fluctuations in sales, working capital assets increase or shrink to match sales levels. At the same time, the asset-based loan increases or decreases, matching borrowings with asset levels.
What is an example of a business that can benefit from this structure?
Manufacturing, distribution, seasonal and high-growth businesses are great examples. The best candidates have good internal controls and accounting software. Also, the quality of a company’s accounts receivable and inventory controls and its ability to ‘turn’ these short-term assets quickly is a plus. The quality of the company’s working capital assets also will determine what percentage the bank is willing to lend. The higher the quality of these assets, the higher advance rate the lender can offer, which translates into more borrowing availability for the borrower.
What types of businesses are best suited for asset-based loans?
High-growth companies; this structure is ideal for companies with a great deal of working capital assets. Companies with direct contracts with government entities or foreign accounts receivables also make good candidates. With proper documentation, the lender may be able to advance a higher percentage on these specific receivables.
Companies going through an ownership transition or estate planning that leverage the balance sheet may also benefit. In addition, highly leveraged companies or companies in a turnaround situation are good fits and can take advantage of the flexibility asset-based structures provide.
What is the lending formula for an asset-based loan?
Advance rates for accounts receivable may range from 60 percent to 95 percent. The asset-based lender will base this advance rate on the quality or collectability of the receivables. Advance rates on inventory may range from 20 percent to 70 percent, depending on the type of inventory and how often the borrower turns or sells the inventory each year. Commodity inventory or finished goods may allow for a higher advance rate, as they are readily marketable.
In the past, asset-based lenders typically did not lend against work-in-process (WIP) or inventory not in final form, because it was difficult to determine the cost or likelihood of converting it to salable inventory. Today, some lenders will lend against WIP, but the advance rates may vary.
What qualities do banks look for in a company before extending an asset-based loan?
The company should have a quality accounting system and internal controls. This indicates that the company is invoicing in a timely and effective manner, which ultimately produces better cash flow -- including solid inventory controls. A perpetual inventory system with periodic physical counts is a plus. Solid internal controls and systems also will assist the borrower with the daily, weekly or monthly reporting requirements of the asset-based lender.
How do you know if a company’s internal controls are acceptable?
The asset-based lender will conduct a field exam, during which the examiner will evaluate various issues, including credit policies and collections, books and records, systems, controls and inventory. The examiner will interview company personnel and review accounts receivable, accounts payable and inventory reports. In addition, they may take a physical inventory or spot-check specific items for accuracy.
Ultimately, asset-based loans allow businesses the flexibility to match their borrowing needs to actual asset (revenue) growth. Asset-based lenders can respond quickly to companies’ needs for more working capital with an asset-based structure, increasing the loan amount along with borrowers’ receivables and inventory.
BRUCE GUEST is senior vice president and division manager of asset-based lending for FirstMerit Bank in Akron. Reach him at email@example.com.