Asset-based Lending

What is Asset-Based Lending?

Asset-based lending involves providing a loan secured by a borrower's assets, often utilized by companies, individuals, and small businesses, wherein the assets serve as collateral for the loan.

The subject is interesting because it involves what happens in the business world. You may be asking yourself, how is asset-based lending vital to me? It is an accounting concept used frequently in the finance industry. This is because this concept is at the heart of financing activities.

A person who does not have an accounting background may have heard the term being used. They may not fully understand the concept behind the phrase. But, regardless of a person's academic background, this article distills the concept into a simple form.  

Commercial banks and financial institutions like to use this form of lending because it's easier and has a shallow risk for the lender. Using a specific formula, banks evaluate the value of the asset relative to the credit amount the client is applying for.

This business process involves loaning a person or company by collateral under certain agreements. Commercial banks make this type of loan to individuals, small businesses, companies, and institutions. 

Understanding Asset-based lending

A company can hold different types of assets. As a result, these assets vary and are recognized differently on a company's balance sheet. It is important to note that these lending can be based on any of these assets.

The following are the assets that can be used as collateral when borrowing.

• Accounts Receivable
• Marketable Securities
• Equipment

Buildings and infrastructure are generally considered less liquid compared to assets like accounts receivable or marketable securities, but they can still be accepted as collateral by lending institutions, depending on their value and marketability.

Banks and financial institutions prefer to minimize risk and maintain liquidity, which is crucial due to potential client withdrawals and loan repayments. Thus, banks aim to balance liquid and illiquid assets to manage claims and withdrawals efficiently while optimizing profitability.

Lending institutions worldwide frequently utilize asset-based lending, among other lending approaches. This is because it is considered less risky than lending without collateral. In addition, banks and financial institutions have a very low risk tolerance because of the nature of their business model.

Reasons for Asset-based lending

There are several reasons why banks and financial institutions commonly use this form of lending.  

• It is safe and less risky to lend money when collateral is offered. Banks and lending companies mostly prefer this form of lending because of the security of the collateral. This is because collateral provides the lending institution with a means to recover the loss.
• It clears doubt on the borrower's capacity to repay the loan after being given the money. The collateral secured by the lending institution or bank does more than remove doubt of payment; it also guarantees recovery when a client defaults or fails to pay.
• It makes accountability easy for the lending institution. 

Asset-Based Lending Formula

A formula is used in the computation for the loan's value to the asset. This is sometimes called the loan-to-value ratio by the banks and lending institutions. 

However, this is the preferred method of valuing an asset before a loan is given to an individual or a company.

Commercial banks and lending institutions use a formula to give loans. The procedure used to calculate the value of an asset is called the loan-to-value ratio. To calculate, we use the formula:

Loan-to-Value Ratio = Loan Amount / Asset Value

In this formula, the value of the assets is determined and divided by the loan amount applied for by the client. Then, the loan-to-value ratio is determined. 

Example of Asset-Based Lending

A bakery needs industrial-grade ovens valued at $50,000. They opt for lease financing:

Lease terms are:

• Monthly payment: $1,000
• Term: 5 years
• Residual value: $5,000
• Down payment: $0

Now, let's see the calculation:

Calculate the total lease payments over the lease term

$1,000 (monthly lease payment) x 12 (months per year) x 5 (years) = $60,000

Subtract the residual value from the total lease payments to determine the total cost of leasing

$60,000 (total lease payments) - $5,000 (residual value) = $55,000

Compare the total cost of leasing with the cost of purchasing:

• Total cost of leasing: $55,000
• Cost of purchasing outright: $50,000

In this scenario, the business owner might decide to lease the equipment because it allows them to acquire the necessary equipment without a large upfront investment and spread the cost over time.

Additionally, at the end of the lease term, they can either return the equipment or purchase it at the predetermined residual value.

Advantages of Asset-based Lending

The following are the advantages. These can be categorized as advantages to the lender and borrower.

To the Lender

The following are the advantages to lenders:

• Asset-based lending processes are typically faster compared to uncollateralized lending due to the presence of collateral, which streamlines the approval process. Lenders gain confidence due to the low risk associated with the type of assets used as collateral. This is why banks and financial institutions like this form of lending.  
• There is a shallow risk as opposed to uncollateralized loans. There is an alternative solution when a client fails to meet their obligation.
• There is confidence in the covenant with the borrower when collateral is involved in the transaction. The bank or the lending institution relies on the business to pay the loan. It acquired assets and recovered the money when the business defaulted.
• Asset-based lending fosters transparency and strengthens the long-term relationship between the lender and borrower, contributing to its popularity as a financing option. This is because the lender gets to have faith in the client's business. For this reason, asset-based lending remains the most common form of financing. 

To the Borrower

The following are the advantages to the borrower:

• Borrowing becomes faster and more accessible for the borrower due to quicker approvals facilitated by the presence of highly liquid collateral. Additionally, asset-based lending often streamlines due diligence processes, benefiting borrowers.
• Asset-based lending typically involves fewer agreements for borrowers, simplifying the loan acquisition process and reducing bureaucratic hurdles.

Asset-based lending offers both borrowers and lenders advantages, facilitating faster and simpler business transactions for all parties involved.

Disadvantages of Asset-based Lending

There are several drawbacks or disadvantages to this form of lending. This is true, especially for the borrower or client. Thus, before deciding to acquire a loan, weighing the disadvantages of asset-based lending is vital. 

The following are the disadvantages of asset-based lending. These disadvantages are binary, and both apply to lenders and borrowers:

• Accounting records are frequently scrutinized by lending institutions or banks. This allows the bank to control the business accounts. Thus, by nature, asset-based lending is called an "all-or-nothing covenant." Asset-based lending agreements may limit the company's flexibility in utilizing other accounts, potentially constraining its financial decisions and autonomy.
• Asset-based lending tends to limit the amount a client or business can borrow. This means the client can only borrow a fraction of the value of the assets and not 100%. In other words, the client can borrow a certain percentage of the asset's fair value, not the asset's total market value.
• It limits the company's ability to leverage other accounts unrelated to the asset-based lending agreement. It has been criticized for its restrictive nature, particularly in limiting a company's ability to leverage assets beyond those the lending agreement covers. The stringent rules the lender applies have been said to make asset-based lending unattractive.
• Asset-based lending loan agreements tend to have high interest rates. This is one of the discouragements to borrowers.
• Other fees, such as processing, auditing, and due diligence, make asset-based lending unattractive to some clients. These fees form part of a finance charge and are applied to the amount used. 
• There is a very high risk of losing your asset when you delay or default to repay the loan. Hence, the bank or lending institution can possess your asset, resulting in challenges in business operations.

Researched and authored by Mazyopa Jonathan | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Advance Rate
• Asset Financing
• Asset-Backed Commercial Paper (ABCP)
• Bridge Financing
• Collateralized Loan Obligations (CLO)