Finding the right financing solution for a small to mid-sized business is always difficult, even if the company is doing well. Most financial institutions prefer to work with larger companies. Larger companies often have longer track records, more assets, and are seen as being less risky. Unfortunately, this perception leaves many well-managed small companies with few financing options.

One alternative that has been gaining popularity in recent years is asset based lending. As its name implies, asset based lending allows you finance your business by using existing assets. This type of funding provides your company with more liquidity, which you can use to manage the business more effectively.

What can asset based lending be used for?

Asset based financing is flexible and can be used to solve a number of business problems. Usually, lines are used to:

• Improve cash flow, especially if clients pay invoices in net 30 to 60 days
• Finance existing purchase orders
• Manage turnarounds
• Finance inventory
• Acquire assets

How does asset based financing work?

Generally, the lending company allows you to finance a percentage of the assets. For example, most accounts receivable are funded at 80%. Inventory and machinery, on the other hand, are funded at lower levels. The financing margin for these assets is often 50% - 75% of liquidation value.

Lines that are backed by accounts receivable and inventory are usually structured to work like revolving lines of credit. Your company gets funding as new invoices are generated or as inventory is acquired. These types of transactions settle as inventory is turned into products and as invoices pay.

On the other hand, lines backed by machinery or other allowable assets (e.g., real estate) are usually structured like term loans. Your company gets the funding upfront and payments are amortized over a period of time.

In cases where your company has multiple asset types, the lines combine a revolving credit facility and a term loan.

How is inventory financed through an asset based loan?

One of the most important features of an asset based loan is that it can be used to finance inventory. It offers a way to free up cash if you have excess inventory, have slow production cycles, or need to pay suppliers quickly.

However, adding inventory to the line increases the complexity of managing the line. The lender will send an examiner on a regular basis to reconcile your reports against existing inventory.

Advantages of asset based lending

Asset based loans have a number of advantages over other solutions. The most important advantage is that they are available to small and mid-sized businesses. Actually, asset based loans don’t even require the business to have perfect financial statements. The financial statements just need to be reasonable and the company needs to have a solid management plan in place.  

The line can be a great tool to help improve the liquidity of your company, especially if you have strong assets like accounts receivable and inventory. Additionally, these financing lines have fewer restrictive covenants than conventional loans and can be obtained quickly.

One important – but often overlooked – advantage of asset based loans is that they can be used as a stepping stone to other financing products. Companies that implement these solutions effectively can often reach the point where they can qualify for lower-cost conventional financing.

Limitations of asset based lending

Although asset based financing has a number of advantages, the solution also has some limitations. The most obvious and important limitation is that your company must have assets that can be financed. If you finance your accounts receivable, your invoices must be payable by creditworthy commercial clients. Additionally, other assets, such as inventory or machinery, must have a reasonable liquidation value that enables you to finance them.

Lastly, asset based loans are more expensive than conventional financing and require regular monitoring. Therefore, they are not the best solution for everyone.

Things to consider when selecting an asset based lender

Selecting an asset based lender requires careful planning. The most important question to ask a lender is if they are familiar with your industry and are comfortable with your asset mix. Different lenders have different asset preferences. It’s best to avoid lenders that do not have experience in your industry.

You should also ask how long they have been in business and how they are funded. This last question is seldom asked but is extremely important. You need to make sure your lender is well funded so that they can support your future growth.