Almost every business reaches a point wherein they are in need of urgent working capital. Where do businesses turn to in such situations?
In most scenarios, they approach a bank to seek the extra capital. Perhaps the most common way to secure extra funds is by applying for a line of credit through a bank. But, in today’s increasingly congested lending marketplace, business owners are provided with numerous other options.
‘Asset based lending’ is a term that keeps cropping up when alternative sources of working capital are mentioned. How does asset based lending differ from a traditional line of credit offered by banks? Read on to find out more.
Traditional Line Of Credit Offered By Banks
For any line of credit offered by a bank, there are usually three factors that play an important role viz. a company’s balance sheet, income statement and the asset offered as collateral. Any collateral offered by a business is not subject to routine supervision. Traditionally banks are on the lookout for positive equity, dependable earnings and a moderate debt to equity ratio, with strong cash flows that are sufficient enough to meet the principal repayment and interest terms on the loan.
Other than a quarterly or annual review of financial statements, usually there is hardly any monitoring for traditional lines of credit offered by banks. The reviews are conducted to determine if all the financial compliance standards are met and audits are usually done on an infrequent basis (if at all).
Such loans usually involve lower rates of interest and longer repayment terms, even if the principal amount offered might be lower than what you are likely to receive through asset based lending.
Majority of the approval and underwriting process depends on the financial performance of the business in the recent past and is usually very paper intensive. Thus, if you are a growing business and looking for a quick influx of funds to capitalise on a growth opportunity, you would find it very difficult to obtain the required funds due to the paper and time intensive nature of conventional bank loans.
Also, if you want to increase the borrowing amount, it might prove to be difficult to convince the bank to increase the line of credit without having to go through the entire process again.
The primary reason why many of the major banks are able to offer small business loans at reduced interest rates is because they rely on multiple streams of revenue, a strong deposit base and low head counts. Additionally they are heavily reliant on financial reviews conducted periodically and can attract new investors.
Asset Based Financing
Asset based finance is directly linked to the valuation of the assets owned by a business. Amongst all assets accounts receivable belongs to the strongest asset class anchoring the loan. The principal amount loaned is in some portion dependent on inventory, real estate values and equipment. Such type of finance is comparatively more progressive than traditional bank loans as it heavily based on the collateral, whereas bank loans take into account the past performance of a business.
Most lenders offering asset based finance require a borrowing base certificate in order to log all the important assets available. The customer is asked to prepare this certificate which helps the lender to determine how much of an initial amount they are eligible for.
How frequently this document is prepared varies from lender to lender and is dependent on how credit worthy the borrower is as well as the value of the assets offered as collateral. It could be done weekly, monthly or when a draw request is made.
Unlike conventional bank loans, such types of loans usually undergo greater scrutiny. Periodic audits are usually conducted to ascertain the valuation of assets offered as collateral. The frequency of these audits could vary from quarterly, semi- annually to once every year and again, is dependent on how credit worthy the borrower is as well as the value of the assets offered as collateral.
Advance percentages, pricing and administrative technicalities might differ from one lender to another. One of the biggest benefits of asset based finance for emerging businesses is that it could open the doors for a conventional bank loan down the line. The influx of capital will help the business to maintain a strong income statement and balance sheet, both of which are mandatory pre-requisites for a bank loan.
Which Type of Loan Should You Go For?
A lot of important factors should be given due consideration when deciding the ideal type of finance suited to your business’s current needs. Hopefully, at the end of this article you have a greater understanding of how conventional bank loans differ from asset based finance and are in a stronger position now to determine the right type of finance for your business.