How asset-based loans from commercial finance companies differ from traditional bank loans

When it comes to the different types of business loans available on the market, homeowners and entrepreneurs can be forgiven for getting a little confused at times. Borrowing money for your business isn’t as simple as walking into a bank and saying you need a small business loan.

What will be the purpose of the loan? How and when will the loan be repaid? And what type of collateral can be pledged to back up the loan? These are just some of the questions lenders will ask to determine a business’s potential creditworthiness and the best type of loan for your situation.

Different lenders offer different types of business financing, which are structured to meet different financing needs. Understanding the main types of business loans will go a long way to helping you decide the best place to start your financing search.

Banks vs. Asset-based lenders

A bank is often the first place business owners go when they need to borrow money. After all, that’s primarily what banks do: lend money and provide other financial products and services, such as checking and savings accounts, and treasury and business management services.

But not all businesses will qualify for a bank loan or line of credit. In particular, banks are reluctant to make loans to start-ups that do not have a track record of profitability, to companies that are experiencing rapid growth, and to companies that may have experienced losses in the recent past. Where can companies like these turn to get the financing they need? There are several options, including borrowing money from family and friends, selling stocks to venture capitalists, obtaining intermediate financing, or obtaining an asset-based loan.

Borrowing from family and friends is often fraught with potential problems and complications, and has the potential to significantly damage friendships and close relationships. And raising venture capital or intermediate financing can be time consuming and expensive. Also, both options involve giving up your company’s share capital and perhaps even a majority stake. Sometimes this equity can be substantial, which can be very costly in the long run.

However, asset-based loans (or ABLs) are often an attractive financing alternative for businesses that do not qualify for a traditional bank loan or line of credit. To understand why, you need to understand the main differences between bank and ABL loans – their different structures, and the different ways that banks and asset-based lenders view business loans.

Cash flow vs. Balance Loans

Banks lend money based on cash flow, looking primarily at a company’s income statement to determine whether it can generate enough cash flow in the future to pay off debt. In this way, banks primarily lend based on what a company has done financially in the past, and use it to assess what can realistically be expected in the future. This is what we call “looking in the rear view mirror.”

In contrast, commercial finance asset-based lenders look at a company’s balance sheet and assets, primarily its accounts receivables and inventory. They lend money based on the liquidity of the inventory and the quality of the accounts receivable, carefully evaluating the profile of the company’s debtors and their respective concentration levels. ABL lenders will also look ahead to see what the potential impact is on accounts receivable from projected sales. We call this “looking through the windshield.”

An example helps illustrate the difference: Suppose ABC Company just landed a $ 12 million contract that will be paid in equal installments over the next year, resulting in $ 1 million of revenue per month. It will take 12 months for the full amount of the contract to appear on the company’s income statement and for a bank to recognize it as cash flow available for debt service. However, an asset-based lender would view this as balance sheet receivables and would consider making loans against them, depending on the creditworthiness of the debtor company.

In this scenario, a bank could lend with the margin generated by the contract. With a 10 percent margin, for example, a bank that lends at 3x margin could lend the business $ 300,000. Because it looks at ending cash flow, an asset-based lender could lend the business much more. money, maybe up to 80 percent of accounts receivable, or $ 800,000.

The other main difference between bank loans and ABL is how banks and asset-based trade finance lenders view the assets of the business. Banks generally only make loans to companies that can pledge hard assets as collateral, primarily real estate and equipment, which is why banks are sometimes referred to as “dirty lenders.” They prefer these assets because they are easier to control, monitor and identify. Asset-based commercial finance lenders, on the other hand, specialize in lending against assets with high speed, such as inventory and accounts receivable. They can do it because they have the systems, the knowledge, the credit appetite, and the controls to monitor these assets.

Apples and oranges

As you can see, traditional bank loans and asset-based loans are actually two different animals that are structured, secured, and valued in totally different ways. So comparing banks and asset-based lenders is like comparing apples and oranges.

Unfortunately, many business owners (and even some bankers) don’t understand these key differences between bank loans and ABL. They try to compare them in terms of apples to apples, and they especially wonder why ABL is so much “more expensive” than bank loans. The cost of ABL is higher than the cost of a bank loan due to the higher degree of risk involved in ABL and the fact that asset-based lenders have invested heavily in the systems and expertise necessary to monitor accounts for collect and administer guarantees.

For businesses that do not qualify for a traditional bank loan, the relevant comparison is not between ABL and a bank loan. Rather, it’s between ABL and one of the other financing options: friends and family, venture capital, or intermediate financing. Or it could be between ABL and missing the opportunity.

For example, suppose that company XYZ has the opportunity to sell $ 3 million, but needs to borrow $ 1 million to fulfill the contract. The contract margin is 30 percent, resulting in a profit of $ 900,000. The business does not qualify for a bank line of credit for this amount, but can obtain an asset-based loan at a total cost of $ 200,000.

However, the owner tells his sales manager that he thinks the ABL is too expensive. “Expensive compared to what?” the sales manager asks him. “We can’t get a bank loan, so the alternative to ABL is not to get the contract. Are you saying it’s not worth paying $ 200,000 to earn $ 900,000?” In this case, saying “no” to ABL would effectively cost the company $ 700,000 in profit.

Look at ABL in a different light

If you’ve avoided applying for an asset-based loan from a commercial finance company in the past because you thought it was too expensive, it’s time to look at ABL from a different perspective. If you can get a traditional bank loan or line of credit, you should probably go ahead and get it. But if you can’t, be sure to compare ABL to your true alternatives.

Viewed from this perspective, an asset-based loan often makes for a very smart and profitable financing option.

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