Asset Based Lending (ABL) originated in the US. In the 1990s the practice was introduced into the British business ecosystem. It is a system of financing that uses assets such as equipment or company inventory (also known as ‘stock’) as security against a loan. Whereas factoring uses unpaid invoices as collateral against prepayments on money due from invoices, asset based lending spreads its net wider to secure collateral. Often it is the case with big operations that they will use a factoring facility in conjunction with asset based lending.
Difference Between Invoice Factoring and Asset Based Lending
The key difference between these two forms of financing arrangements is that an invoice financier involved in factoring will buy unpaid invoices. In the case of ABL, the assets are not bought. Instead, security is taken against the assets. In the event of bad debt, a company will be obliged to sell the asset to cover the debt. The asset will be insured and the benefits of the insurance policy assigned to the lender. This is to protect the lender against any damage occurring to the asset while it is being used as collateral.
Inventory or Stock
A company’s inventory is consists of items that are ready for sale. It also covers materials that can be turned into inventory or stock. Thus, raw materials and incomplete inventory are also included in this category.
When stock is used as surety against a loan, it is called ‘stock financing’. In order to qualify for this type of financing a company will have to produce detailed and up-to-date stock reports.
It is not just the amount of stock that needs to be considered, but also the quality of the stock. In the event that a company cannot repay its loan, the stock will need to be sold to cover the shortfall. Therefore, the financier will assess how easy it is to sell stock. Hi-tech, seasonal and bespoke products might not be easy to sell. A company might have stock worth a lot of money but finds it hard to quickly source customers for its stock. Promoting a new product, marketing etc. is not a service that a financier provides.
To protect the assets used in asset based lending a financier can either take legal charge of the asset or just ‘floating charge’ of the asset. The first means the financier has control of the asset. The second means a company can still use and sell the asset as in normal trading conditions. If the company stops trading a financier will move from floating charge of an asset to legal charge of an asset.
How Much Can Be Raised Against Stock?
This is the key question for the company offering asset based lending. They will bring in an expert to evaluate the stock. They assess how easy it would be to sell the stock if the borrower defaults. Included in these calculations are storage and transport costs. These types of stock evaluations are made annually. Armed with this information a financier can set limits on funding that can be secured against stock.
To dig deeper, the financier will place ‘retentions’ against stock based on a number of criteria. Retentions, in this instance, refers to money withheld and not available for financing purposes. This is similar to the retentions an invoice financier will place on invoices that are over a year old etc.
Here is a list detailing these retentions:
- Damaged stock. No funding will be available against damaged stock. In the event that the stock is badly damaged an insurance claim will be made with the funds going to the lender.
- Work in Progress. Unfinished inventory still counts as ‘stock’ but a financier will place a retention on these items, especially if the process for completing the items will be costly and complicated.
- Slow moving stock. A financier will usually place retentions against using slow moving stock as an asset to borrow against. A super yacht might be a high value item but with Russian oligarchs being thin on the ground, it might be stuck in a dry dock for a long time.
- Short Shelf Life. Items with a short shelf life such as perishable items are not suitable for asset based lending.
- Obsolete, aged and out-of-date stock. Obsolete could refer to stock that is no longer relevant such as merchandise for the Euros 2020. Aged refers to items that have been in the warehouse for a long time that are not looking likely to be sold any time soon. The exception to aged stock triggering a retention is whisky that is increases in value with age. Any item that is labelled out-of-date is also subject to retentions since it might not even be legal to try and sell such stock.
- Selling costs. The annual evaluations of stock will assess the overheads involved in selling stock such as bills for warehousing, transporting and electricity. These costs will be accounted for in the retentions.
- Retention of title. This refers to a situation where the supplier maintains legal ownership of the parts or materials it has supplied until its client has made a sale and paid off its supplier. This type of stock is not a viable asset for securing a loan against and is thus subject to retention.
- Unsecured creditors. In the UK if a company goes into liquidation, then the administrators will have to set aside stock that can be used to pay off unsecured creditors. This can be up to £600,000. Retention will be made to cover this possibility.
Costs of Stock Finance
Borrowing comes with fees. When a financier sets up a stock facility, he or she will set out a number of fees:
- Administration fee. This will be the cost for administering the finance facility and may include the costs of the stock audits. The fee will depend on the complexity of the stock reporting and if there are multiple locations involved.
- Interest on the amount borrowed. The interest rate will always be higher than the central bank’s interest rates. It will also be higher than the discount charge that features in factoring costs.
- Valuation fees. This is the cost of assessing the value of the stock and assessments over things such as how easy it would be to sell stock in the event there was a default in loan repayments.
As with invoice finance, a calculation is made to show the amount of money that is available to be borrowed. Firstly, the total stock value is assessed and then deductions are made for out-of-date, damaged and obsolete stock. Deductions are made for the costs of selling stock (electricity, transport etc.). And deductions are made for unsecured creditors. After deductions a stock financier will set a percentage for how much he or she will lend against the remaining stock value. It is typically between 50% and 80%. This figure is the ‘availability’.
Stock Finance vs Invoice Finance
The availability percentage is normally higher for invoice finance than for stock finance. This is because collecting debt from unpaid invoices is considered less expensive and less risky than selling stock. Moreover, evaluations are more accurate with invoice finance: a stock financier will be basing their decisions on monthly stock reports that can be up to 4 weeks out-of-date.
Another worry for a stock financier will be the quality of the remaining stock for sale. A failing company will quite often sell their best stock first to deal with shortfalls in cash flow or to fulfil debt repayment obligations.
How Fluctuations in Stock Value are Managed
Just as with factoring where the total value of the sales ledger is fluctuating month by month, so the value of eligible stock (stock that is not obsolete etc.) is changing from month to month. A company could use all its availability for stock finance one month only to discover that the following month their debt is beyond the limits set by availability. This typically happens if there is a good month of sales and the stocks are diminished as a result.
In the event of a company finding itself in this position, the stock financier will demand a payment to address the overpaid position. This payment could be delayed because a company is waiting on invoices to be paid.
A more savvy move for a company is to use invoice finance in conjunction with asset based lending. Thus, if a company finds itself in an overpaid position it can use its recent unpaid invoices to raise funds to rectify the problem.
Managing a Stock Finance Facility
There is considerably more leg work involved in managing a stock finance facility than in managing an invoice finance facility. Periodic stock reports have to be analysed. Spot checks by an independent auditor have to be conducted to check that stock is really in the warehouse. And then there is the annual valuation to conduct and analyse. These annual valuations will often be set for various times in the year to build up a picture of seasonal variations. Consideration also has to be given for ageing stock and changes in stock price.
Borrowing Against Machinery and Property
Asset based lending is also possible using not only stock but also plant machinery and commercial property. Borrowing against machinery and property is referred to as a ‘term loan’.
The financier has to do due diligence on the value of the machinery or property used as collateral for a loan. This includes assessing the value of the asset if it is sold quickly as opposed to waiting for 12 months for a better offer. The costs of storing, maintaining, securing and insuring equipment and property must be calculated. And lastly, the market for the equipment held as collateral for a loan needs to be considered.
Another cost is registering with the Land Register and Companies House (for UK) that there is a charge against a commercial property in connection to an outstanding loan. In the case of equipment, insurance contracts that make the lender the beneficiary will need to be put in place.
Normally loans against machinery are repaid over 3 years. Loans against property are repaid over 7 to 15 years.
In this context of costs for using machinery or property to secure financing the following fees apply:
- A one-off administration fee to set up the loan facility
- Interest on the value of the outstanding loan. This is usually higher than the ‘discount rate’ offered with invoice finance.
- Fee to conduct valuations
A company can raise funds against its stock, equipment or commercial property. This type of financial product is called asset based lending.
In the case of borrowing against stock, detailed inventories are needed of materials, unfinished stock and stock ready for sale. Retentions are made for ageing stock, out-of-date stock, damaged stock and obsolete stock. The percentage of the stock total value that the asset based lender is willing to lend is lower than with invoice finance because of the difficulties inherent in selling stock if there is a payment default.
In the case of borrowing against company equipment and property, a terms loan is offered. This is subject to regular checks; updates in value; fees for making changes to the Land Register and at Companies House; and to making the lender the beneficiary of any applicable insurance policies.
A large manufacturing operation will often use both asset based lending as well as invoice finance to fund its operation.