Understanding Asset-Based Lending

Traditional business financing, in which lenders primarily assess a business’s cash flow, works well for many companies. But while cash-flow lending depends on the strength and stability of a company’s cash flow, some businesses may be eligible for additional borrowing based on the assets they own. For them, an alternative known as asset-based lending, or ABL, may be preferable.

With ABL, a broad range of your company’s assets— ranging from accounts receivable to real estate and even brand names and intellectual property—can serve as collateral, unlocking needed capital. If your business has substantial assets, ABL may provide access to significant financing with a covenant-light structure, while also offering a level of flexibility in making future decisions that may not be possible with other types of loans. Special arrangements such as FILO tranches (for "first in, last out") could increase the amount you’re able to borrow.

Whether ABL is the right choice for your company depends on a close examination of your needs, the kind of business you have, your current situation and your plans for the future.

The way in which your company is evaluated for ABL financing differs from the more familiar process for cash-flow financing. Cash flow usually involves standard metrics such as your funded debt divided by EBITDA (earnings before interest, taxes, depreciation and amortization), your EBITDA margin (EBITDA as a percentage of revenue) and operating cash flow.

With ABL, a lender will instead focus primarily on the value of your business’s assets, which are used as collateral to secure a loan. First on the list is accounts receivable; typically, only current receivables (those that are less than 90 days from invoice date or no more than 60 days past due) are considered. Next come assets such as inventory, machinery and equipment, real estate and intellectual property.

As part of this process, your company will undergo field examinations to determine the level and quality of its financial and physical assets. The field examination and inventory appraisal determine the eligible collateral and the advance rates against them.

One advantage of the ABL approach is a relative freedom from the covenants that usually come with cash-flow lending—for example, requirements that companies maintain certain levels of debt service coverage and leverage. When a company faces a drop in sales—as so many did during the coronavirus pandemic, for example— faltering cash flow could mean it fails to meet its covenants. A lender could reduce credit availability, increase interest rates or take other measures to protect against loan losses. With ABL, by contrast, having your loan backed by your business’s assets minimizes a lender’s worries about a possible default. Your business will need only to maintain a minimum level of liquidity to avoid being subject to a financial covenant.

Prime candidates for ABL are asset-rich companies that may have variations in cash flow but need significant capital to help them operate and grow. That description could apply to a broad range of businesses.

Many companies deal with ups and downs as part of normal operations. Suppose, for example, that your company manufactures commercial truck trailers. When the economy stalls, demand for many goods is likely to fall, bringing down freight hauling volume and reducing orders for new trailers. Moreover, truck tractors typically have to be replaced more often than trailers, and trucking firms may opt to use their capital expenditure budgets to purchase tractors before costly new fuel efficiency regulations go into effect, for example. Yet despite fluctuations in cash flow, you need capital to weather dips in volume and to be able to expand and modernize production—and you have sufficient assets to qualify for a sizeable ABL line of credit.

Distribution businesses are another good candidate for ABL. If your company is a wine and liquor wholesaler, for example, it will likely experience seasonal fluctuations in sales. Yet you may need to stock up in advance of summer and winter holidays, and there could be a gap between when payments are due to your suppliers and when you turn the inventory and are able to collect from the bars, restaurants and liquor stores you supply. Having a line of credit to draw upon could give you needed flexibility.

Retailers that have significant inventory but earnings volatility may also benefit from ABL. That was the case during the early months of the pandemic, when a national shutdown suddenly shuttered clothing chains and other retailers. Some were able to use ABL to fund operations and enhancements to their online presence, and an ABL facility provided greater liquidity than their existing cashflow financing.

For these and other kinds of companies, ABL may bring a particularly welcome bonus. You often can draw upon your line of credit without seeking a lender’s permission. For example, if you want to make an acquisition, enter a joint venture or declare a dividend, you would have the flexibility to deploy the capital quickly without prior approval as long as you meet certain payment conditions.

As noted previously, accounts receivable and inventory will be evaluated through a field examination. Collateral evaluation could also include third-party appraisals of inventory, machinery and equipment, real estate and intellectual property.

However, some assets may not be good collateral for an ABL facility. For example, in the case of a construction company, lenders may not feel comfortable lending against accounts receivable that could be difficult to collect due to progress billings, retention or the presence of bonding requirements. And some assets are so specialized that they wouldn’t be valuable to another company. One example might be inventory made to a customer’s specifications; another could be a business with a significant amount of inventory with product packaging and labels where a change in name or ownership would make those worthless. In terms of inventory, perishable goods may have expiration dates that limit their value.

With ABL, you will typically need to provide monthly reports updating the status of your borrowing base—the collateral on which a credit facility depends. That kind of reporting can add an extra level of paperwork and expense for companies that choose asset-based lending, but innovations in automation can help simplify that process.

Bank of America Business Capital’s commitment to digital transformation and focus on making business easier for clients has led to the development of an automated reporting tool that enables borrowers to upload all of the needed information into the bank’s system, instead of filling out multiple forms for every reporting period. That degree of automation can speed up and simplify the reporting process.

For the right kind of business and situation, ABL may unlock more capital than cash-flow formulas would permit. Companies that experience seasonal or cyclical ups and downs in sales; those that are subject to commodity price fluctuations; retailers with ebbs and flows in revenues; and other asset-rich businesses that want flexibility to deploy capital may find that ABL offers the flexibility and access to capital they need to stay competitive in an ever-changing economy.

If you would like to know more about the possibilities of ABL and whether it could help meet your need for capital, please contact your Bank of America Business Capital specialist.

Different lending approaches for different needs