Asset-Based Lending: a Worked Example

A cash-flow lender asks how many years of earnings the debt represents, and stops lending when the answer looks too high. That works for a business with steady earnings. It works badly for one whose earnings have just fallen, swing with the seasons, or are about to recover from a bad year, because the multiple punishes the business at exactly the moment it needs working capital. Its customers still owe it money and its warehouse is still full.

An asset-based lender reads those assets instead. Receivables turn into cash within weeks, whatever the profit and loss account says, and stock can be sold. If the lender knows what the assets are worth on a forced sale, controls where the cash from them goes and checks them often, it can lend a share of their value with less reliance on the earnings forecast. The trade is visibility for flexibility: more money, in return for more reporting and less freedom over cash.

Each part is negotiated. Eligible receivables strip out invoices that are overdue beyond an agreed age, owed by related companies, disputed or subject to set-off, or concentrated on one customer beyond a concentration limit. Stock is usually valued on an independent appraisal of what it would fetch in an orderly sale, and work in progress and slow lines often earn little or nothing. Reserves are deducted for claims that could rank ahead of the lender or eat into the collateral: rent owed to a landlord who could otherwise hold up access to the stock, and in an insolvency, claims the law puts first. In Australia, employee entitlements are paid ahead of security interests in circulating assets in a winding up or receivership. In New Zealand, the employee and tax claims that Schedule 7 of the Companies Act 1993 makes preferential rank ahead of a security interest over accounts receivable and inventory, unless it is a perfected purchase money security interest or a perfected purchase of the receivables for new value. In the UK, preferential creditors, including HMRC for some taxes since December 2020, rank ahead of a floating charge.

The borrower reports the base on a borrowing base certificate, weekly or monthly. The lender tests it through a field exam, confirms invoices through debtor verification, and often has collections paid into an account it controls. Financial covenants tend to be lighter than in a cash-flow facility; many agreements carry a single fixed charge cover test that applies only once availability falls below an agreed level, a form of springing covenant.

A maker of corrugated cardboard packaging, constructed for this page like every figure in it, lost its largest customer and absorbed a jump in energy costs in the same year. EBITDA fell from US$8m to US$3m. It has won replacement work but needs US$14m drawn to carry its ledger and paper stock. A cash-flow lender willing to lend three times EBITDA, a multiple chosen for the example and not a market norm, would stop well short:

The assets support almost twice what the earnings do. The ineligible US$3m of receivables is mostly invoices over 90 days and one customer's balance above its limit; the ineligible stock is work in progress and obsolete print runs. The advance rates are the example's. They come from the lender's reading of this ledger's dilution and this stock's appraisal, and a different ledger would earn different ones.

The US$2.5m of availability is the number that runs the relationship from here. If two large customers pay late and slip past 90 days, the base falls and the drawn balance does not, and availability shrinks without anyone signing anything. The facility tightens itself as the collateral weakens, which is the point of building it this way.

DEFINED IN ONE PARAGRAPH → · THE BORROWING BASE CERTIFICATE → · AVAILABILITY →

A cash-flow facility is sized once, on earnings, and policed by covenants tested each quarter; between tests, the limit does not move. An asset-based facility is sized continuously, on collateral, and policed by reporting; the limit moves every time a certificate is delivered. The first lender's protection is early warning through ratios. The second's is that the loan cannot grow much larger than what the assets would repay.

It also differs from plain invoice finance. An invoice discounting line funds one asset, the debtor book. Asset-based lending usually combines receivables, stock and sometimes plant in one revolving facility, with a term loan against machinery alongside it in many structures. In the UK the larger multi-asset form is an established product of banks' specialist teams and independent lenders; in New Zealand and Australia it is offered by fewer providers and is often marketed as debtor or trade finance, with stock added.

The choice between the two structures is usually made when a cash-flow lender declines or offers too little. The questions then move from the profit and loss account to the ledger: how old are the debts, how concentrated, how much is credited away after invoicing, and does the stock sell. A business with a clean ledger and saleable stock can be refinanced into a larger facility. One whose receivables are mostly progress claims, retentions or invoices to related companies may find the base is smaller than its overdraft.

The cost to the borrower is not only the margin. It is the monthly certificate, the field exam fees, the loss of free use of its collections once availability tightens, and a lender that will see a bad month within days. For a business that expects to recover, that is a fair trade. For one that does not, the shrinking base is how the lender finds out first.

CASH DOMINION → · SLOW-MOVING STOCK → · DILUTION →