Asset based loans are a broad category of loans that simply mean that an asset, a group of assets or numerous different assets are placed as collateral for a loan which can be either a term loan, revolving credit or trade lines. The lender’s exposure is secured by the assets in the event of default – it’s like a home mortgage where your house is the security for the loan. There are numerous uses to asset based loans (sometimes called ‘asset backed’ loans) some more common than others. We will look at two uses and how these two uses are funded.
Leveraged Buy Outs
Back in the 80′s the term, LBO or MBO were such buzz words. It seemed that everyone was doing it. What it stood for was ‘Leveraged Buyout’ or ‘Managed Buyout’. It was an ingenious mechanism where the raider – the person who was buying the company, used the assets of the target company to buy it. What they would do is review the books and look at all the assets the target company had and if there was sufficient cash flow to service the loan, and there was sufficient assets to secure it, the lender would step in and provide the funds to buy out the existing shareholders. Sometimes the raider, or buyer, would hardly fork out a penny. This is a form of an asset based loan. There are two parts to this, first is the asset and second is the loan, both are mentioned below in turn.
Assets in all companies, big or small, are divided into current and fixed assets. Current Assets referring to assets that can be converted to cash fairly quickly and Fixed Assets where it takes a little longer time. Depending on what the loan is used for, the different assets can be used to collateralize them. For instance a term loan to purchase a building can be secured by the building itself and possible other fixed assets that the borrower owns. Short term assets, asset which can be converted quickly, can be used for short term loans and small amounts. These include, but are not limited to, receivables, inventory and time deposits (cash).
Asset Based Loans
Based on the assets listed in the Balance Sheet it is possible to find a lender who is willing to provide loans on the certainty of payback and in the event payback is a problem, the lender is willing to take the assets. These asset based loans when used to conduct leveraged buyouts result in buyers with almost no money themselves use the finds of a lender and the surety of payment of the target to eventually assume control of the company. An ingenious idea that made a lot of people very reach in the 80s and 90s.
Asset based loans can even be used to buy up a competitor. Imagine being able to buy up your competitor who is doing well and instantly increasing your market share, just by using your competitor’s own balance sheet to fund your purchase. But for a more modest and immediate use, the Asset Based Loans are used to finance working capital needs.
Working Capital Requirements
There are two quirks that you need to be clear about. First off, Working Capital is defined in finance as the difference between Current Assets net of Current Liabilities. This just means that if you take all your obligations – what you owe others, and you subtract that from your current assets – what you own and what others owe you, what your left with is resources to be able to apply towards further expansion or the running of your day to day operations – that’s working capital.
The second thing you need to know, that this does not necessarily mean cash. You could have a high working capital figure if you had high receivables, but that does not mean you have a load of cash ready to pay your obligations.
Working Capital Loan(Asset Based)
In this scenario asset based loans are specifically used to extend the needs of a company to fulfill new orders – or working capital. A loan is secured from the bank using the current assets as collateral and each time an obligation classified within the loan agreement is presented to the bank, the bank checks if the payment qualifies. With everything in order, the bank releases the funds to the creditor. In this case, the borrow is fully responsible for the repayment of the loan.
Another form of Asset Based Loans is the practice of Factoring. Factoring is highly versatile, yet simple mechanism that is available to most trading and manufacturing companies who issue invoices to financially sound customers. The benefit of Factoring is that the creditworthiness of the customer is assessed by the Factor (the entity purchasing the invoice) in determining the viability of the customer. If they accept the customer’s risk, they will buy the Invoice and pay the Invoice value minus a discount to the customer. There is no recourse to the customer at this point unless the customer does not fulfill its end of the contract.
Asset based loans come in many forms. Strictly speaking the loan to purchase a warehouse is also based on the warehouse – and as such is an asset based loan. But in working capital terms the asset refers to collateralization of almost any of the asset classes and any of the items that fall under the asset list. By far the most under appreciated Asset Based Loan is Factoring. It has not been in the limelight and most people do not use it to expand their business or use it to increase their operations.