When working capital starts to become a critical day to day challenge Canadian business owners and financial managers must consider all business financing options.
One of the most growing in popularity options, and often mis understood is an asset based line of credit. This type of financing comes under the broad category of asset based lending and the simple definition of such a facility is the ability of your firm to maintain an operating line of credit, outside of a bank relationship. How is that possible? Let’s examine 3 critical factors that you need to know and understand to effectively use such a financing solution.
1. What assets are financed under this facility and how does this differ from a bank facility
2. How does the facility Work on a day to day basis
3. What are the fees involved and how much can we get from a total working capital perspective
Let’s start with our first critical factor – exactly what is this type of facility? An asset based line of credit in its true sense, and in the context we are discussing is a working capital revolving credit. The assets that are secured under this facility are accounts receivable, inventory, and in many cases equipment and actually sometimes real estate.
We poised the question – how does this facility work when we compare it to a charted bank line of credit. In actuality it is quite similar, with the main difference being that 99% of the time you can extract additional borrowing power out of the assets we mentioned. That is simply because a bank focuses on overall financial health and considers a number of external metrics to the actual line of credit – these include balance sheet and income statement rations, personal guarantees, outside collateral, and the overall nature of your industry and business model.
Asset based lines of credit in fact tend to eliminate many of those considerations, and focus only on one key point – the assets! Because that is the case receivables and inventory are margined up, via traditional borrowing based certificates, to a much higher level than might otherwise be maintained with traditional financing. When you factor in working capital that is secured by equipment, you can quickly see that your borrowing capacity has increased significantly.
Let’s examine a very typical solution that we see with our client base everyday. A firm has a bank facility, or is self financing in some cases, and essentially their only working capital relies heavily on accounts receivable. If your firm gets more borrowing power from you A/R, has the ability to throw inventory into the mix, and can secured additional funds via some unencumbered equipment which is used working capital collateral you can quickly see how a 150,000 line of credit could become a 400,000 line of credit in very short form.
Let’s move on to point # 2- how does this facility work based on any current financing arrangements you have? Similar to a bank revolving line of credit your borrowing capacity in an asset based line of credit is simply the drawing down, on a weekly, monthly, or in fact anytime basis, of your total borrowing capacity based on your reporting of current A/R, inventory and equipment levels. A quick example – lets assume for simplistic purposes you haven’t drawn anything down – you send in your borrowing based certificate showing receivables of 500k and inventory of 300k. (Previously it was determine you could draw 90% of A/R and 60% of inventory) That would allow you to receive immediate funds of 630,000$.
Some factors that might make this facility a little less are the overall age of your receivables, or if you only have a couple of concentrated accounts. Key to mention here is that under this type of facility you are reporting more often on the assets and their turnover, so that should be considered and of final point, fees and borrowing limits.
Asset based lines of credit typically cost more than the bank- In Canada these facilities are priced from 7-9% per annum to 1-2% a month . What determines this huge spread in pricing? It is the overall asset quality and size of the transaction , as well as the ability of many asset based lenders to do transaction that would normally not be anywhere near to be considered by a bank, and as such, the risk is higher, so pricing is higher . It is as simple as that. In terms of what amounts you can borrow, you can assume 90% of A/R, a 40-60%+ range on inventory, and a similar amount for equipment. (Equipment would often be subject to a market value appraisal) . Very standard legal costs, due diligence fees, and origination fees usually are part of the term sheet you will receive .
Does your firm need more working capital? Are you self financing now. Are you unable to access traditional financing, or, more commonly, does traditional financing seem unable to meet your growth or unique situation needs? If so, speak to a trusted, credible, and experienced financial advisor in asset based lending.