According to the Commercial Finance Association, asset-based loans hit $420 billion last year, compared to about $113 billion in factored loans. Don Starkey, senior vice president at Comerica Bank in San Diego, says the popularity of asset-based loans from a bank is, in part, because of lower interest rates and less frequent reporting requirements.
Smart Business spoke to Starkey to outline the dynamics of asset-based loans and to explain the formula to understanding the transactions.
How does an asset-based loan work?
Simply put, it’s a collateralized loan or line of credit where the credit limit is set based on the value of the collateral securing that loan. Acceptable collateral can be anything from accounts receivable, inventory, equipment and real estate, to patents, copyrights and trademarks.
What types of businesses are best suited for asset-based loans?
Many thriving businesses choose asset-based loans to:
- Leverage assets as a means of supplementing working capital or funding an acquisition, allowing a business to grow beyond what it might otherwise be capable of;
- Increase flexibility of lending arrangements through fewer loan covenants, higher credit limits, and fewer restrictions on the use of proceeds permitting a business to react quickly to opportunities, and
- Decrease lending costs, as many banks charge higher interest rates for unsecured loans versus asset-based loans.
What qualities do banks look for in a company before extending an asset-based loan?
First, size is not a factor. Businesses large and small qualify for asset-based loans.
Second, collateral is king. The larger the asset base, the larger the potential credit limit.
Third, a business needs to have internal controls in place to regularly report to a lender the value of its collateral base. The key to getting more value assigned to a specific pool of collateral is to help a banker understand the business, the market for that collateral, and the strength of the industry as a whole.
How do you know if a company’s internal controls are acceptable?
A lender is more flexible in an asset-based lending arrangement because the loan is supported by collateral. Values of that collateral pool can change. For instance, the value of accounts receivable and inventory can fluctuate daily, whereas the value of equipment can fluctuate more gradually over months or years.
To ensure that the company’s credit limit does not exceed the value of the collateral pool, lenders ask businesses to monitor and report updated values daily, weekly, monthly or annually. To ensure that these controls are acceptable, most financial institutions conduct an audit of a business’ reporting mechanisms at least annually.
What is the difference between an asset-based loan from a bank and a similar arrangement with a factor or finance company?
Factoring companies typically charge about 1 percent monthly for all new receivables factored, also known as a ‘factor charge.’ A bank usually doesn’t charge this. In addition to the factor charge, the factoring company charges interest at rates in many cases at 1 percent to 5 percent higher than what a bank might charge. Last, but not least, a factoring company typically requires a business to report its collateral values on a daily or weekly basis. A bank is usually satisfied with weekly or monthly reporting.
Although more costly and labor-intensive in many cases, factoring companies will typically loan a business more than a bank on the same collateral pool and will ask for less restrictive financial covenants.
What is the lending formula for an asset-based loan?
Consumers use them all the time, whether obtaining an equity line secured by a home or a line of credit secured by a securities portfolio.
Asset-based loans for businesses work much the same way. Most lenders establish credit limits equal to a percentage of the collateral value. From a lender’s perspective, collateral value is equal to market value less liquidation costs. Then a credit limit is established equal to a percentage of the collateral value, typically up to 80 percent against eligible accounts receivable, up to 50 percent of quality inventory, up to 80 percent of new equipment, up to 75 percent of used equipment, and up to 75 percent on commercial real estate. Credit limits for other collateral types (patents, trademarks and copyrights) are highly subjective and are determined on a case-by-case basis.
DON STARKEY is a senior vice president for Comerica Bank and manages the firm’s San Diego Middle Market Banking Group. Reach him at (619) 338-1541 or firstname.lastname@example.org.