With help from JJ Richa
The next logical step in our analysis of financing tools is to analyze asset-based lending, in which you pledge or assign your short term assets, such as accounts receivable or inventory, to the lender. Often, the lender then tracks the pledged assets until money is received or inventory sold, expecting repayment from the proceeds of sale.
Asset-based financing is a specialized method of providing structured working capital and term loans that are secured by accounts receivable, inventory, machinery, equipment and/or real estate. This type of funding is great for startup companies, refinancing existing loans, and financing for growth, mergers and acquisitions.
One example of asset-based finance would be purchase order financing. This may be attractive to a company that has stretched its credit limits with vendors and has reached its lending capacity at the bank—or possibly a startup company without adequate financing. The inability to finance raw materials to fill all orders would leave a company operating under capacity. An asset-based lender finances the purchase of the raw material. The purchase orders are then assigned to the lender. After the orders are filled, payment is made directly to the lender by the customer, and the lender then deducts its cost and fees and remits the balance to the company. The disadvantage of this type of financing, however, is the high interest typically charged.
Handling the reporting for such loans often require some amount of dedicated time. Many lenders require that a transaction report be generated along with a batch of purchase orders or invoices pledged as collateral for the loan. The lender has the right to reject any individual pledged item, and then calculates a percentage of the value as the amount to loan. Ranging from 50% to 80%, you can request an “advance” up to your credit limit, beyond which no more is available, and you must rely entirely upon your own devices to finance further transactions.
Each transaction report also contains a list of money received against pledged items, so that the calculation of available credit remains fresh, and based upon remaining invoices that are not yet overdue. Government invoices are usually not accepted, and any new invoices from accounts that have outstanding invoices more than 60 days overdue are usually also exempted, as are invoices to concentrated customers who account for a significant percentage of the company’s business.
Asset-based financing is not cheap. Lenders often tack on charges for management of your account, for a “float” of cash to account for the number of days to clear payments received, and for a periodic audit of the company’s accounts. Adding all of these often adds an additional 3–8% to the stated interest rate of the line of credit, sometimes making it one of the more expensive methods of finance.
Finally, some asset-based lenders are “factors” who actually purchase your invoices, hold back a portion of the proceeds to protect against future bad debts, then deduct their fees before remittance and remit a net amount, with the final amount to be remitted upon collection of the money owed by the customer to the factor. Factors redirect your customer’s payment to the factor’s postal lock box. You never see the cash collected, since the invoice is owned by the factor, no longer by you.
There are many other forms of financing a small business. Let’s explore some of them.
This article was originally published by Berkonomics