Maintaining steady cash flow is a very common struggle in running a construction business, especially among small- to medium-sized companies. You often have to shell out money to fulfill your payroll and other financial obligations, even if the payment for your previous project is yet to arrive.
There are different financing methods that can help you deal with this issue. One such method is asset-based financing, or asset-based lending. By using this method, you are able to cover your immediate financial obligations while waiting for your invoices to get paid.
This guide will answer your basic questions about asset-based financing and how it can possibly help you run your business more smoothly.
- What is asset-based financing?
- How does asset-based financing work?
- When to consider taking out an asset-based loan
- How lenders determine the amount for an asset-based loan
- Differences between asset-based financing and other financing methods
- Advantages of asset-based financing
- Things to consider when taking out an asset-based loan
What is asset-based financing?
Asset-based financing or asset-based lending is a financing method in which you use your assets as collateral when taking out a loan from a lender.
When you borrow money from a lender, the lender will most likely require you to provide them some assurance that they will not be left empty-handed in case you default on your loan. If you borrow money from a lender through asset-based financing, you are using your upcoming payments or your physical assets as your so-called collateral.
This means that in the event that you are not able to pay back your loan, the lender will rightly collect your upcoming payments and/or seize your equipment as a way to recover the money that they lent you.
How does asset-based financing work?
Lenders implement asset-based financing differently. Here are some examples:
Company A needs to furnish materials to complete orders for a project but they do not have enough money to do so. Company A reaches out to a lender for an asset-based loan. The lender then buys the materials for the company and the company directs the purchase orders to the lender.
When the client pays the purchase orders, the lender receives the payment and deducts the interest and fees and sends the remaining amount to Company A.
In this scenario, the lender shoulders the immediate expenses of a company and they use the company’s receivables as assets.
Company B asks a lender for an asset-based loan by using their heavy-duty machinery as collateral. The lender allows Company B to have access to a pool of money, similar to a revolving line of credit. Company B has to pay back what it gets from this pool; otherwise, the lender might seize their machines.
This scenario is an example of an asset-based line of credit in which fixed-price machinery is used as collateral. The lender has the security of owning the equipment in case the company defaults on the loan.
Assets used as collateral when taking out asset-based loans
Assets for asset-based financing can include accounts receivables or the payment for invoices that you are expecting. You may also use your equipment, machinery, or stock inventory as assets if you want to secure an asset-based loan.
Can you use the same asset as collateral for multiple asset-based loans?
You usually may not use the same asset as collateral for different asset-based loans from different lenders. Most lenders will decline your application if they find out that your asset is already promised to another lender. However, lenders may also strike a deal among themselves, so using the same asset may still be possible.
In most cases, however, an asset may only be used for one specific asset-based financing deal.
When to consider taking out an asset-based loan
Asset-based loans may be for companies with a considerable amount of assets, whether it be a large construction account for a project or expensive equipment machinery. To give you a ballpark figure, most asset-based financing deals are priced between $750,000 and $1,000,000 so you must have a considerable asset around this range.
An asset-based loan is also helpful for parties who have already reached their credit limit with a bank. Borrowing money from a bank is ideal for certain parties because of low interests, but sometimes parties may max out their borrowing capacity. Taking out an asset-based loan may help them alleviate their financial concerns if traditional banking is no longer an option.
An asset-based loan may also be ideal for companies that are not big enough to qualify for traditional bank loans but already have enough assets to their name so they don’t have to go through invoice factoring, which is another funding option that’s typically used by smaller construction companies.
How lenders determine the amount for an asset-based loan
The amount that a lender will let you borrow will depend on the asset that you are willing to set as your collateral for the loan. Typically a lender lends 75% to 85% of the asset’s value. Note that if you are in a long-term asset-based financing deal with a lender (e.g. a revolving line of credit), the lender may change the amount of your loan depending on the changing value of the assets.
Keep in mind too that the values of most assets change over time. Accounts receivables may change depending on a project, and the values of equipment and machinery change over time.
Also note that before approving asset-based funding and during the course of a long-term asset-based agreement, lenders will inspect the condition of an asset, verify that it is not encumbered by any other lender, and inspect the transactions that are associated with it.
Differences between asset-based financing and other financing methods
Asset-based financing vs. bank line of credit
A line of credit is typically secured from a traditional banking institution and is therefore subjected to a stringent screening process before approval. Asset-based financing, on the other hand, is approved by a lender depending on the amount of the asset that you are willing to make as your collateral.
Asset-based financing vs. invoice factoring
These two funding methods are often confused with each other because they can both use accounts receivables as a sort of security blanket for the lenders. However, note that in invoice factoring, you actually sell your invoices to a lender. The lender also assumes responsibility for collecting payment for your invoices.
In asset-based financing, you do not sell your receivables – you simply use them as collateral. You are also often still responsible for collecting payment for your invoices. If you fail to pay your lender the money that you borrowed, the lender will have the right to step in and receive payment for your invoices.
Advantages of asset-based financing
1. The approval process is not as strict as that in traditional bank loans.
As long as you have eligible assets, your asset-based loan may easily get approved. You can still have the benefits of a bank’s line of credit without going through the strict application process that banks often have.
2. The lending agreements are more flexible.
Most bank loans can require to spend your loan on specific equipment or for a specific purpose. If you opt to use asset-based financing, you may use the money that you receive in any way you like, so long as you are able to pay it back on time.
3. Immediate expenses are covered to ensure steady cash flow.
Like most funding options for construction companies, an asset-based loan does the job of allowing you to cover the gaps in your cash flow. By using your asset as collateral, you can fulfill your short-term obligations such as payroll requirements even if you are still waiting for your receivables to arrive.
Things to consider when taking out an asset-based loan
1. Approval largely depends on the quality of your assets.
The biggest consideration in availing of asset-based financing is the fact that you first need an asset that is worth a considerable amount before you can consider this funding option. Not only does this mean your asset has to be worth a certain amount, but it also has to be free from any other existing asset-based deals.
2. Approval may also depend on the quality of your clients.
Sometimes your status as a company and the quality of your assets are not the only factors to consider. Lenders also look at the credit ratings and reputations of your clients to assure that you will be able to pay your loans back.