Life is unpredictable; sometimes, despite saving up and investing in the best securities, one may need to borrow to meet certain expenses. This is where loans come in to support individuals and groups on their financial journeys. Asset based lending is one such lending process that strikes the perfect balance between supporting borrowers and securing lenders against malpractice. What is asset-based lending, what are its challenges and how can lenders overcome them?
What is asset-based lending?
- An asset-based loan is a loan secured by an asset or collateral the borrower owns. The borrower formally agrees to compensate the lender with a valuable asset if he or she cannot repay the money within the stipulated timeframe.
- Such assets may include (but are not limited to) property, plant and equipment (PP&E), accounts receivable and securities.
Limitations of asset-based lending and how to overcome them
Lower loan-to-value ratio for illiquid assets
The loan-to-value ratio refers to the percentage of the secured asset’s value that the lender would be willing to provide the borrower. For instance, if the secured asset’s market value is INR1m, a loan-to-value ratio of 70% would mean the lender agrees to provide the borrower loans of up to INR700,000. However, tangible assets such as equipment and property are typically assigned lower loan-to-value ratios. Meaning that if the borrower cannot repay the loan, he or she would incur a loss of 30%.
Solution: Securing liquid assets such as cash and marketable securities is a better alternative, as these have much higher loan-to-value ratios than hard assets. It helps to compare the loan-to-value ratios of different lenders before agreeing to one.
Some assets may not be accepted as collateral
Lenders typically accept only those assets that have high values and are long-lasting and liquid. Thus, not all types of assets secured as collateral. Sometimes, an asset may not meet all of a lender’s conditions and, therefore, not qualify as suitable collateral. While more liquid options such as cash may be better alternatives to hard assets. Some borrowers may not have sufficient funds to secure as collateral and, thus, have no choice but to depend on hard assets.
Solution: Many lenders now accept accounts receivable as collateral against the loans they provide. This is where a percentage of a business’s daily revenue is credited to the lender. This is a simpler and more efficient strategy for securing an asset.
Reduction of collateral value
As mentioned before, lenders prefer liquid collateral to hard assets. Thus, to increase an asset’s liquidity, they may reduce the value of the borrower’s asset when providing the loan. For instance, a lender may value an asset worth INR1m at INR700,000 and sanction the borrower a loan of INR700,000 or less. If the borrower cannot repay the loan, the lender sells the asset at this low price to earn a profit, and the borrower suffers a loss.
Solution: Before settling for a lender, compare the loan rates different lenders are willing to provide vis-à-vis your requirement. It helps to evaluate all the assets you possess and earmark the most liquid of these, which you may offer as collateral. Marketable securities or accounts receivable fare better than PP&E assets.
As a low-risk loan strategy that facilitates a win-win situation for lenders and borrowers alike. Asset-based lending is a popular choice among individual borrowers as well as budding businesses. The ability to use accounts receivable as collateral has increased the appeal of asset-based lending among startups. And other embryonic ventures looking for initial financial support.