What you need to know before signing up for an asset-based line of credit

Does your business have an accounts receivable (AR) collection process?

Are you collecting your ARs timely?

What are your inventory turn days?

The bank wants to know you know your business.

When you’re looking to apply for an asset-based line of credit, it’s important that you know you’re cash flow highs and lows (source and uses). Before signing up for an asset-based line of credit, here’s what you should know:

Traditional line of credit vs an asset-based line of credit

More mature companies typically qualify for a traditional line of credit. Because they are seen as less of a risk to bankers, companies who have been in business for several years, have a strong balance sheet, and low debt leverage, aren’t governed by any type of monthly reporting and can borrow and pay back at will.

Asset-based loans use current assets (AR and inventory) as collateral. Fast-growing companies have a lot of unknowns, experiencing growing pains, and have less of a history, so bankers put them on an asset-based line of credit.

Accounts Receivable

Typically companies that are running AR and inventory based lines of credit are companies that are growing quickly. As a company is growing they need additional working capital, but their cash is generally tied-up in AR and inventory. Banks will put a line of credit and collateralize it with the AR and inventory. A personal guarantee is generally required, too.

Each month the business will submit a borrowing base. In order to access additional monies, the bank needs to see an updated borrowing base – which is basically what you can borrow for that period of time. Say your company is having a really good month and by the third week, ARs have increased from $1 million to $1.5 million. That company can submit mid-month borrowing bases and get access to additional capital based on an agreed upon formula (ex: eligible AR x advance rate) defined by the bank.

Unfortunately many companies don’t take advantage of additional capital because their accounting systems aren’t timely or accurate, so they struggle to submit an updated monthly borrowing base.

Inventory

What your inventory is made up of impacts how quickly you will sell your inventory.

A lot of companies look at their inventory as one number: inventory. However, inventory is broken into three areas: raw materials, work in progress (WIP), and finished goods.

Most banks who finance inventory only want to finance raw materials or finished goods. Very few will touch WIP because there’s very little value in things that are half-baked.

Commodities / raw materials like steel, wood, and resin can be sold to other companies who can develop a product out of it, so these have value. Banks typically will lend a little more against commodity goods because they’re easier to liquidate.

Finished goods have value because you can sell a finished product, like a phone or a table. However, because there needs to be customer base who want or have a need for the good, the market is a bit more limited than raw materials.

WIP essentially has zero value because the bank would either have to scrap the good, like a half-assembled chair, or pay someone to put it together. Whereas the bank may lend between 20-50 percent on raw material and/or finished goods, any WIP in inventory may be deemed ineligible to advance against.

Requirements for asset-based lines of credit

For businesses that are newer, growing quickly, or have risks associated with them, banks typically have requirements (although everything is negotiable), including:

  • At least two years in business
  • Profitable over the last 12 months
  • Forecasted to be profitable over the next 12 months
  • Have accurate and timely accounts receivable, inventory management tools, and reporting systems
  • A personal guarantee of any owners over 20 percent of the business. Depending on the economy, banks get more competitive, they may negotiate each other out of the personal guarantee to win the business.

An annual accounts receivable audit directed by the bank and performed by a third party may be required as well. Depending on how risky the relationship is between the company and the bank, the bank may require bi-annually or quarterly AR audits. These audits can cost the business between $5-20 thousand per AR audit.

Along with checking the accuracy of ARs, bank auditors will also check to make sure dilution is low. Dilution is the number of a company’s receivables that are returned/credited back. The higher the amount of dilution a company has, the greater the risk to the bank.

The all-in cost of signing up for an asset-based line of credit doesn’t come cheap. Most companies don’t realize that they can be required to do quarterly AR audits (which can be another $20k+ expense) or take into account the interest rates (more risk = higher rate), loan fee, plus any additional fees.

Every line of credit has different terms. So before you even go down the road of getting an asset-based line of credit (or any line of credit), you should have a very well-defined (at least 12 month) cash flow forecast to show the bank the use of funds.

 

Contact us today to find out how having a CFO involved can help drive these conversations with your bank and ensure your company gets access to the cash and working capital critical to the growth of your business.