The term asset based lending refers to secured financial loans disbursed against security that may consist of a variety of assets. Businesses are able to borrow money using their current liquid assets like inventory and/or accounts receivable or against fixed assets like plant and machinery, property, equipment etc. by pledging them as collateral against the loan. Asset based lenders assess a loan's credit risk on the basis of the value of the underlying collateral. Real estate mortgages and equipment loans can also be categorized as asset based loans. The lenders in the financial industry, who provide various asset based lending services are commonly referred to as commercial lenders, sometime also called secured lenders.
Usually companies that require increased cash flow for their working capital needs take advantage of the revolving credit facility in asset based lending, if they are unable to obtain an unsecured bank loan, to combine it with their normal cash flow for covering any shortfall of funds. This is also known as a revolver loan. It is a type of asset based lending secured by inventory and receivables of the borrower company. The borrower grants a security interest in its receivables and inventory to the lender as collateral against the loan. This forms the borrowing base for the loan.
As the borrower receives payment against invoices, they are given to the lender for repaying the loan. Whenever the borrower requires additional working capital, the lender again advances him funds on his request. This offers a very big advantage to the borrower allowing him to cover his working capital needs, without waiting for his receivables to be paid in cash. Cash is available for his use, as and when needed and whatever is not required daily is used to pay down the loan balance and reduce the interest burden, as the amount of loan in a revolver may fluctuate on a daily basis.
Since revolvers are secured by receivables and/or inventory, which may change daily, the lender monitors the collateral on an ongoing basis to determine the latest borrowing base, so as to provide the borrower with the biggest possible credit it can support. Advance rate is the maximum percentage of the current borrowing base, a borrower can avail of as loan. If a loan is secured by inventory, which is say 40% raw material, 10% unfinished goods and 50% finished goods, then a secured lender will consider eligible inventory at 90% (discounting the unfinished goods only). Now, if the Advance rate approved for the company is 50% then the loan available would be 50% of the eligible inventory. This would effectively mean (50% of 90%) 45% of the gross inventory value.
To determine advance rate on receivables, rule of the thumb is 1 minus 2 x rate of dilution + 5% i.e.
Advance Rate= 1-[(2D) +.05] where D is dilution.
When dilution is 5% using the above formulae, the advance rate would be 85%.
1-[(2x.05)+. 05]=85%= Advance rate
Dilution - There are factors like warranty returns, wrong/incorrect invoices and bad debt write offs that do not let all invoices be ultimately collected. The difference between the invoices generated by the borrower and what is actually collected is known as dilution. For example, if
Generated invoices = $100,000
Receivables collected = $ 95,000
($2500 is goods returned and $2500 is cash discounts)
