The Downside of Asset-Based Lending

Most small business owners rely on small business loans when they seek financing. However, most small businesses are denied a loan.

When faced with dilemmas, some small to medium sized business owners turn to asset-based lending to get the cash they need quickly. Asset based loans use collateral such as accounts receivable and inventory to secure a loan. While these types of loans provide a much-needed cash infusion, there are downsides to consider.

Limited Assets that Qualify

Depending on what kind of business you are in, you might need to use certain balance sheet items such as trucks, heavy equipment, etc., accounts receivable under 90 days or inventory as collateral.

Some lenders might have more stringent terms and only consider the highest quality receivables you have in 60 days or less. 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.

Low Valuations

You also face the challenge of having an asset that is valued lower than its actual market value. Commercial lenders are looking for a quick sale in the case that you default on the loan.

Asset-based loans can be generated against 70 to 80 percent of qualifying accounts receivable and 50 percent of eligible inventories. It can have serious consequences for your balance sheet. If your collateral increases in value, you will lose even more. It is important to remember that even when the market value increases over time, the limit of your loan will not.

Higher Costs

Compared to more traditional loans, asset-based loans cost more. Loans requiring commercial collaterals are not the only ones that have higher interest-rates some banks might include additional costs such as audit and diligence fees.

Other costs might include your preparation of detailed information about your collaterals. Commercial lenders might require additional appraisals so they can have comparable information to reach a decision.

You might need to incur additional ongoing financial expense 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.

Chance of Losing Assets

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.

Negligible Effect on Business Credit Report

A large percentage of businesses neglect reviewing their business credit reports. Taking on an asset-based loan or other types of secured loans can prevent your company from rebuilding or improving your business credit score as fast as an unsecured loan. A secured loan shows that your company’s financial position is not strong and that you are struggling to make payments.

Hight leverage and higher probability of defaulting on debt payments make your business less attractive in the eyes of the creditors. Your business credit score will show that and it will hinder your chances of getting more traditional loans.

The Bottom Line

Those that could benefit from asset-based lending include companies with high inventory turnaround, have solid financial record keeping, and customers that pay on time. Secured loans are not right for every business owner. Some businesses might lack the necessary assets that lenders require as collateral. Other businesses might not be able to handle 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.