We lend money with a reasonable expectation that we will get it back, otherwise, it would be a called a gift right?
To secure the chances of us getting our money back we can ‘hold’ an asset, something that has an equal or higher value than the overall amount of money we have lent. This principle of secured lending is referred to as asset-based financing or commercial finance.
Offering an asset-based loan is less risky for the lender because if the loan is not repaid or goes into default for any reason, we have something of value that we can sell to recover our money.
The value of any asset used for collateral should cover the original loan amount, any interest we expect to have earned and the cost of selling the asset.
A company can borrow money against its unpaid invoices without waiting for a client to settle their account. Invoice finance is a common form of short-term borrowing, often used to improve a company’s working capital and cash flow position. A business borrows a percentage of the value of its sales ledger from a finance company, effectively using the unpaid sales invoices as security for the borrowing.
Asset based lending:
Loans can be secured with tangible, saleable assets. Assets normally used are typically land and buildings, accounts receivables, stock, machinery, equipment. Increasingly specialist providers are also funding against intangible assets such as intellectual property and brands or soft assets such as IT software, office equipment, and furniture.
Let’s say for example that a lender is looking to cover a loan by at least 150 percent:
If the company borrows £1,000,000, the lender will want to secure the loan with property or assets valued in excess of £1,500,000.
Holding an asset as security for a loan does not guarantee that a lender will be paid back.
A lender must make sure that the asset is valued correctly and a re-sale market is readily available. Lenders should rely on specialised and independent valuations of assets as variations in valuations is common. Relying solely on one valuation or the borrowers opinion of the assets adds risk that an asset could be overvalued, leaving a lender with a loss if the assets have to be sold.
The value of an asset is likely to change with time and with circumstance. When the economy is stable land and property prices may be lasting however if the economy turns valuations may fall leaving lenders exposed to the risk an assets disposable value no longer covering the loan amount.
Due diligence procedures should also include checking the ownership and legal title of assets used for collateral. Company structures can sometimes be complex and assets may be owned by group or associated companies. Prospective lenders should also make sure that there are no other creditors in the queue with preferential rights over the assets being used to secure loans.