The Downside of Asset-Based Lending
More than half of entrepreneurs and small business owners rely on small business loans when they seek financing. However, according to OnDeck Capital, about 82 percent of small businesses are denied a loan.
When faced with the dilemma of trying to meet payroll during a busy season or build up retail inventory for the holiday frenzy and having already maxed out business credit cards, some small- to medium-sized business (SMB) owners turn to asset-based lending to get out of a cash crunch.
Asset-based loans use collateral such as accounts receivable and inventory to secure a loan. While these types of loans can provide a much-needed cash infusion right away, here are five downsides to consider:
Downside #1 – Limited Assets that Qualify
Just because this form of financing is called asset-based lending, it doesn’t mean that you can use all of your assets. Depending on the nature of your business, you may use certain balance sheet items (e.g. trucks, heavy equipment), accounts receivable under 90 days or inventory as collateral.
However, some commercial lenders may have much more astringent terms and consider only your highest quality receivables under 60 days. The Commercial Financial Association (CFA) shows that the historical loss on asset-based loans for banks is less than 1 percent because banks double check the liquidation value of collaterals used in loans.
Downside #2 – Low Valuations
On top of having a small pool of eligible assets, you face the challenge of having an asset valued much lower than its actual market value. Commercial lenders are looking for a very quick sale in case you default on your loan.
Asset-based loans can be generated against 70 to 80 percent of qualifying accounts receivable and 50 percent of eligible inventories.
This can have very serious consequences for your balance sheet. Let’s imagine that you were to use $250,000 in inventory as collateral and the bank only issued $180,000 in financing. In case of liquidation, you get to lose an additional $70,000. Even worse, if your collateral were to increase in value, you would lose even more.
Remember that even when the market value increases over time, the limit of your loan won’t.
Downside #3 – Higher Costs
Compared to more traditional loans, asset-based loans cost more. Loans requiring commercial collaterals aren’t the only ones that can have higher interest rates – some banks may also include additional costs, such as audit and diligence fees. Despite the low historical rates of asset-based loans, banks believe that they can’t be too careful.
Other costs may include your preparation of detailed information about your collaterals, if limited or none are available. Commercial lenders may require additional appraisals so that they can have comparable information to reach a decision.
You may also incur additional ongoing financial expenses, such as preparing updated financial statements and providing current lists of accounts receivables and operating expenses, such as insuring or appraising the collateral, to meet the risk management concerns of your lender.
Downside #4 – Chance of Losing Assets
Under Uniform Commercial Code 9 (UCC 9), in case of default, a financial institution has the right to seize collateral and liquidate it to pay for unpaid balances. In the event that the liquidation sale were not able to cover the debt in its entirety, the secured party would still be liable for the remaining amounts, including applicable interest, processing fees or penalties.
While UCC 9 makes it possible for a secured party to buy back its collaterals during the liquidation sale, it’s highly unlikely that the secured party will have the necessary funds since it can’t make necessary installments in the first place.
Downside #5 – Negligible Effect on Business Credit Report
A large proportion of businesses don’t have a full picture of their credit reports. Two out of three U.S. small business owners haven’t checked their business credit report within the past two years.
Taking on asset-based loans or other types of secured loans can prevent your company from rebuilding or improving your business credit score as fast as your company could with an unsecured loan. A secured loan is a signal that your company’s financial position isn’t strong and that you’re struggling to make payments.
High leverage and higher probability of defaulting on debt payments make your business less attractive in the eyes of creditors. The business credit score will reflect that, hurting your chances of getting more traditional loans.
The Bottom Line
Companies with high inventory turnaround, solid financial record keeping and a base of customers that pay on time could benefit from asset-based lending. However, secured loans aren’t for every business owner. For example, some businesses may lack the necessary assets that lenders require as collateral. Other businesses may not be able to handle the prospect of losing essential equipment to their operations.
The potential of having your short-term cash inflows going directly to a third party may put you in a much bigger financial hole, after all. To decide whether or not an asset-based loan is right for you, make sure to consider all of its advantages and disadvantages and compare its cost to that of alternative forms of financing.
What do you do to manage those cash crunches? Let us know on social media @KabbageInc!