Asset-based lending is a form of credit used by businesses. It refers to a loan that is secured by the assets, meaning something of value, owned by the borrower. Companies typically use this to shore up cash flow issues on a short-term basis. While individuals generally don’t use asset-based lending themselves, it is still helpful to understand how it works to aid in your assessment of companies when considering investments.
For help with building your own portfolio, consider working with a financial advisor.
What Is Asset-Based Lending?
An asset-based loan is a secured loan used by businesses. In this case, the loan is secured by the underlying physical or financial assets of the company. For example, a business might take out an asset-based loan secured by one of its buildings, its industrial equipment, sections of inventory or even payments due in accounts receivable.
Businesses generally use these loans for two reasons:
First, a company might use asset-based lending to cover a short-term cash flow issue. For example, a company that expects to collect significant payments from customers but currently needs cash to pay its bills might take out an asset-based loan.
Second, a company might use asset-based lending to grow and make future investments if it currently has all of its cash tied up. For example, a company that just bought a new warehouse might take out an asset-based loan to buy several new trucks to service that location. They’re in a strong position, but cash-light, so an asset-based loan can give them the money to keep growing.
Collateral and Loan-To-Value Ratio
Since asset-based loans are secured, they generally have lower interest rates than unsecured loans or business credit cards.
However lenders do prioritize collateral that is more liquid. With an asset-based loan, lenders will give larger loans at lower interest rates when the business secures that loan with a more liquid asset. For example, a business that secures its loan with a stock portfolio or its accounts receivable portfolio will typically get better terms than if they secure the loan with industrial equipment or real estate. The former is more liquid and easily marketable, so it is more likely to hold its value. The latter is harder to sell, and so is more likely to add costs if the lender has to collect.
Lenders price asset-based loans on what’s called “loan-to-value ratio.” This is the ratio between the value of the loan and the value of the asset used as collateral. In a standard asset-based loan, the lender will give a higher loan-to-value ratio for more liquid collateral.
For example, say that your business wants to take out an asset based loan. You have two assets that you can use as collateral. First, you can use your accounts receivable. You have $100,000 in pending payments from customers that you can stake as collateral. Second, you have a pair of trucks that are collectively worth $120,000 together.
As a cash asset, the accounts receivable is a far more liquid asset. So your lender may agree to an 80% loan-to-value ratio, extending you an asset-based loan worth up to $80,000.
The trucks are less liquid than accounts receivable. If your lender has to collect, they will incur additional costs in getting and selling those trucks. So they may agree to a 60% loan-to-value ratio for an asset-based loan secured by the trucks, extending you a loan of up to $72,000.
Asset-Based Lending In Real Estate
Asset-based loans are relatively common in commercial and investment real estate.
One of the features of some real estate firms is that they tend to be property-heavy and cash-light. Buying real estate costs an enormous amount of money, so it’s common for a firm to spend that money on its next investment property. This can frequently leave real estate firms cash-light when they need to pay bills or when they want to make a new purchase.
To solve this cash-flow issue, real estate firms will often use asset-based loans backed by their real estate holdings. The loan can change based on the underlying value of the property involved.
For example, a real estate firm might take out an asset-based loan secured by the market value of a property they own. Or it might take out a loan backed by the income of a rental unit. The sale-price of a property will typically generate lower loan-to-value ratios, since real estate sales are illiquid. The cash flow of an income-generating property will typically generate higher loan-to-value ratios, since this is highly liquid.
Regardless of the value, real estate firms have significant assets they can use to secure an asset-based loan.
The Bottom Line
An asset-based loan is a business loan secured by property, cash or other assets owned by the business. They are popular for real estate firms, as these loans can help a cash-light firm purchase new investment properties.
Real Estate Tips
- Real estate investing is a popular way to add diversity to your portfolio — and to create passive income.
- A financial advisor can help you make the investment choices that are best for you and your family. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Photo credit: ©iStock.com/kate_sept2004, ©iStock.com/andresr, ©iStock.com/andresr