Asset-Based Lending Can Provide Working Capital

What are your chances of borrowing working capital from a bank if your business already carries some debt and, worse, rests on a thin capital base in the first place?

If your answer is “slim to none,” think again.

If you own a business with high-quality receivables and inventories, you may qualify for what bankers call asset-based lending. The technique works well for wholesalers and distributors, but bankers also sell these loans to some manufacturers and even to service businesses such as temporary-help agencies.

The benefit of asset-based borrowing is that it speeds cash flow, freeing capital otherwise tied up in receivables and inventory, and when it fills the bill, it can prove a powerful tool to make a company grow.

What’s more, bankers send asset-based loan money out the door at prime plus 1 or 2 points--sometimes even at prime for a good customer. So capital raised by this kind of borrowing counts as cheap money.

The trade-off? Paperwork. An asset-based loan doesn’t cost much, but you jump through some paperwork hoops to put such a loan in place, and you jump through more to maintain it.

Technically, an asset-based loan is a revolving line of credit secured by inventory and receivables. In plain English, this means that:

* You borrow against the value of your receivables and inventory, essentially shortening the time it otherwise takes to turn these assets into cash.

* You use the money as working capital to buy more inventory.

* You pay interest only on what you use.

* And if you go belly up, the bank gets its money back by taking possession of your inventory and receivables and selling them.

Banks target asset-based loans at privately held businesses such as wholesalers and distributorships, which often show thin capital bases and operate on low margins. The loans allow such businesses to turn over inventory rapidly--their key to profitability. As a rule publicly held companies don’t use asset-based financing because they show fatter capital bases, not to mention the financial muscle to tap other sources for working capital. Retailers don’t qualify for this kind of financing because they’re usually cash-and-carry operations.

“If the borrower wants a line of credit for working capital, we review the financials and do our underwriting,” says Thomas R. Kelly, vice president of Comerica Bank of California. The bank, which has offices in Westwood and 31 other California locations, targets small to mid-size privately held businesses with revenues from $10 million to $250 million. It offers unsecured open lines of credit to businesses with healthy cash flow, plus loans secured by such things as fixed assets, accounts receivable and inventories.

“Let’s say the business qualifies for $500,000 in an open line of credit and we offer that much,” Kelly adds. “Then, if the business needs more and it’s comfortable with the reporting requirements--which means giving us monthly information on receivables and inventory--we’re able to give the business more money by going to asset-based lending.

“By doing this, we stretch the envelope and give the business as much credit as possible.”

Asset-based borrowing allows a business to multiply its working capital by “layering” a secured loan on top of an unsecured open line of credit. Cash flow, which assures the bank that you can repay the unsecured line of credit, supports the first layer. Receivables and inventory support the second.

As with other business lenders, Kelly says, Comerica looks at a business’ debt-to-equity ratio in deciding how to layer the loans. If the borrower shows good cash flow and a balance sheet with less debt than equity--that is, a debt-to-equity ratio of less than 1--the bank may offer an unsecured open line of credit such that total unsecured debt comes to 1.5 times equity.

That makes up the first layer. Once the debt-to-equity ratio gets to 1.5, the bank offers another loan secured by receivables and inventory, Kelly says. For this layer, the bank lends between 65% and 85% of the value of receivables, plus another sum ranging between 10% and 55% of the value of inventory.

“We look to finance raw materials or finished goods,” Kelly says. “That means raw materials coming in and finished goods going out. We don’t lend on work in progress.”

A company borrowing against receivables and inventory ends up with less equity but more working capital. But businesses such as wholesalers and distributorships make money on inventory turnover. The more often they sell their inventory, the more profit they make.

For example, take a wholesaler with $10 million in inventory, on which the business expects to make a 2% profit, or $200,000. If the business ships everything in its inventory on Jan. 1 but doesn’t collect until March 1, it turns over inventory only six times a year, for a $1.2-million profit.

But asset-based financing should allow the business to turn over inventory seven or eight times a year, adding $400,000 more to profit, Kelly says. The multiplier effect benefits other businesses with big receivables as well--for example, temp agencies.

To get this kind of financing, you must show:

* Three years of your business’ financial statements and tax returns;

* A current interim financial statement, along with a statement from the same period last year;

* Aging reports analyzing accounts receivable and payable for the same two periods, plus a listing of your top customers;

* Your own personal financial statement plus your tax returns for the last two to three years.

* Your business plan showing projections over the next year.

Most asset-based loans go for terms of one year, although Kelly says this may soon stretch to two years. To renew the loan at the end of the term, you supply updated financials and tax returns for both your business and yourself.

There’s more paperwork. Banks want monthly reports detailing accounts payable and receivable plus a “borrowing base certificate” recording sales, collections and net collateral, Kelly says.

The paperwork burden notwithstanding, asset-based lending proves a valuable source of working capital for many businesses, he adds.

“Most businesses lack liquidity,” Kelly says, “and the more liquidity you can get, the faster you can grow your business. Asset-based lending allows the business to obtain more credit. It gives the business the liquidity it needs to grow.”

NEXT: How a Los Angeles-based company used asset-based financing to spur its own growth.

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Freelance writer Juan Hovey can be reached at (805) 492-7909 or by e-mail at jhovey@compuserve.com