A simple guide for small business owners on asset based lending
If you’re a small business owner seeking outside capital to support your company’s growth, we know it can be difficult to secure loans from banks and traditional lenders. Asset-based lending is a great alternative option that doesn’t require several years of operations or a stellar credit history.
In this article, we’ll break down what asset-based lending is and how it works.
What is asset-based lending?
Asset-based lending is the business of lending money through an agreement that is secured with collateral. This means that before any money can be loaned, the lender and borrower must first agree on an asset owned by the latter to serve as collateral.
Collateral is an asset provided by the borrower to serve as payment for the loan in the event that the borrower fails to make repayments within the agreed upon time frame. In such an instance, ownership of the asset would be transferred to the lender who will liquidate it and convert it to cash.
In asset-based lending, the lender’s risk is dependent on the value of the asset the borrower provides. If a borrower provides an asset that can be converted immediately to money, this lowers the risk in lending to them. If the asset cannot be liquidated, it’s considered high risk.
Lenders will use the loan-to-value ratio of an asset to determine its loan-equivalent.
What is a loan-to-value-ratio?
A loan-to-value-ratio compares the loan value requested by the borrower to the value of the pledged collateral. It determines the maximum loan amount a lender is willing to give based on the loan-to-value percentage. The ratio is calculated with this formula:
Loan-to-Value Ratio = Loan Amount / Value of Asset
- The loan amount is the amount requested by the borrower
- The value asset is the value price of the pledged collateral
The loan-to-value ratio states up to what percentage of the valuable asset the lender is willing to provide. If you’re the borrower, you can use this ratio to determine which assets you should put up in order to receive your desired loan amount.
Here’s a concreate example:
A borrower wishes to receive a loan amount of $100,000. The lender has provided an 85% loan-to-value ratio for marketable securities and 40% for machinery.
Let’s say the borrower’s machinery has a value of $250,000 while their marketable securities has a value of $100,000. If you multiple each by their loan-to-value ratio, the machinery’s value comes to $100,000 and the marketable securities value comes to $85,000.
- $250,000 (machinery value) x 40% (machinery loan-to-value ratio) = $100,000
- $100,000 (marketable securities value) x 85% (marketable securities loan-to-value ratio) = $85,000
By calculating each, it’s easy to see that the machinery is the best option to put up in order to receive the full $100,000 loan amount.
When evaluating your own collateral options, you should also consider which are easier to liquidate. Account receivables, including payments owed from clients that have yet to be paid, are recommended as they are easier to convert to cash, whereas properties are more difficult to liquidate.
If the collateral you put up is considered high risk or difficult to liquidate, an asset-based lender can also consider your credit history, inventories, company books, and the timeliness of your clients’ payments to see whether they should grant your loan request.
What are the advantages of an asset-based lending option?
If you’re a small business owner, this type of financing is most likely going to be easier to obtain than a business loan or line of credit. You don’t need to have a long credit history to prove you are creditworthy. All you need is a good asset to pledge as your collateral, and to be able to show a short track profitability record for your business. (Proof that it’s in good financial control.) Asset-based lending also comes with lower interest rates compared to other lending options.
Asset-based lending can be a great resource for that much-needed capital especially if your business is rapidly growing. If you are considering this to help finance your small business, we hope that this article has helped you understand more about it and how it works.