Is Asset-Based Lending, Accounts Receivable Financing right for my company?
In a previous article, we attempted to explain the difference between Asset-Based Lending (“ABL”), Accounts Receivable Financing and Factoring. You can read about those differences here. However, for purposes of this article, we will use Asset-Based Lending as a generic term for all three credit facilities.
Hopefully, now that we understand the differences, we shall explore if any of these financing vehicles make sense for your company. Fundamentally, an Asset-Based Lending product provides businesses with working capital. A business early in the business life cycle and looking to expand, will typically not qualify for traditional bank financing due to a lack of sufficient operating history. A larger company may look to leverage their trading assets (Accounts Receivable and Inventory) for an acquisition, additional growth, for a recapitalization after a downturn or simply to meet operating expenses occurred during the normal course of business. There are also situations where Asset-Based Lending is not appropriate and should not be utilized. We discuss both sides of the equation below.
Let’s first look at scenarios where Asset-Based Lending can be very beneficial to a company.
Historical losses but a profitable future
A company that has recently sustained operating losses may well be turned down for traditional bank financing. However, that same company may have pending orders or contracts that will put it on the path back to profitability. Without financing, the company cannot fulfill the orders or execute on the contracts and may not be able to get back in to the black. Unlike the bank, an Asset-Based Lender will focus less on the historical losses and place more emphasis on the prospects for the future. Without the working capital assistance from an alternative lender, the company’s path to profits will be a difficult.
Start-up or early stage company
Banks are cash flow lenders and analyze a company’s historical cash flow to determine their ability to service debt. Early stage companies usually do not have the historical profits and cash flow to provide to a bank. Many business owners may consider taking on a partner; however, equity is the most expensive form of capital and nobody likes giving up a percentage of their business. An Asset-Based Lender centers its due diligence on the collateral (hence the name) focusing more on the quality of the Accounts Receivable and Inventory when making a lending decision. In many instances, a favorable review of the collateral pool leads to an approved working capital facility despite losses and a lack of historical information.
Business Owner with challenged personal credit
Sometimes a small business will have strong historical cash flow and looks like an ideal bank customer only to be thwarted by the owner’s personal credit score. Most banks have a minimum threshold for personal credit; scores that fail to meet that threshold are not approved despite the company’s financial strength. While Asset-Based Lenders will make personal credit a part of the decision process, it’s only one factor and by itself (except in egregious circumstances) not usually cause for an automatic turn down.
As with with other credit products, there are also scenarios where Asset-Based Lending, Accounts Receivable Financing and Factoring are not favorable:
An Asset-Based Line of Credit or a Factoring Facility is designed to improve cash flow. It rarely makes sense for a company to draw on their working capital line of credit to make large purchases. These expenditures (machinery, equipment, real estate, etc.) are more appropriate for term loans that amortize over a given timeframe.
Low margin businesses
The financing cost with an Asset-Based Lender is usually greater than with a traditional bank. A company that operates on low margins may not be able to absorb the additional expense associated with a Factoring Company or an Asset-Based Lender. The increased borrowing costs could lead to a problem in the long-term despite the short-term cash flow improvement. As is true with all lending products, it is important the borrower has a firm sense of the bottom line benefit versus cost of a particular loan product before moving forward.
As with any new credit facility it’s important to discuss options with your trusted advisors to make sure you have the appropriate structure that best fits your business.