In our article "How to deal with your lenders during COVID-19 - The elbow tap" we highlighted the need to: have a plan, gather key financial information to inform the plan, and state clearly what you are asking for. For some businesses, asset backed loans may be the solution.
When the economy is strong and predictable, lenders will lend against forecast earnings and cash flow. However, in the current, uncertain environment most companies are finding forecasting impossible. Asset Backed Loans, known as "ABLs" focus on the here and now and provide a dynamic source of financing that can grow, or shrink, to fit a business during uncertain times.
Cash flow lenders test against forecast Debt to Earnings Ratios and Debt Service Cover Ratios to monitor the health of the business. Their exit strategy in a default scenario generally depends on being able to sell the business as a going concern at a price determined at a multiple of earnings. All well and good until it is impossible to forecast.
An ABL lender will instead focus on the assets the business holds and will seek to determine how much it would recover by liquidating those assets at any point in time. ABL lenders will lend against accounts receivables, inventory and property plant and equipment at a percentage of valuation. By combining receivables and inventory in one borrowing base you may be able to significantly increase the amount of available debt, making ABLs more attractive than traditional receivables funding or factoring products.
Accounts receivable
These are valued by reference to the credit quality of the debtors, the rate at which they turn and the likelihood of recoveries. A good track record of working capital management and collecting will enhance the percentage loan available and trade credit insurance can be used to mitigate debtor credit risk to further increase the amount of funding available.
Inventory
Lenders will focus on how much they would recover on a liquidation, often referred to as the "net orderly liquidation value". This will be a function of the value of the product, how and where it is stored and the ease with which it can be got to market and sold.
WIP financing
Conceptualised either as inventory funding for service industries or pre-receivables financing. Enhanced modern reporting capabilities mean service industry participants or manufacturers can borrow against contracted WIP, enabling those businesses to collateralise a larger part of their supply chain.
Boot collateral
Generally the available funding under and ABL will be sized off a borrowing base that is determined by reference to accounts receivables and inventory, and/or WIP. However, many ABL lenders will also take into account property, plant and equipment to enhance the borrowing base or support more aggressive lending against a receivables and inventory based borrowing base. In this way borrowers can generate funding using a portfolio of business assets which might not be capable of being financed individually.
Information is key
ABL lenders are information junkies (or as one of our clients describes itself "collateral geeks"). The more information you can provide, the more comfortable they will be able to get. They will generally ask borrowers to generate rigorous monthly, or even weekly, collateral reports. ABL has in the past sometimes been seen as an onerous and labour intensive. However, most businesses have made significant advancements in tracking their accounts, stock and assets in recent years and more detailed reporting can be a small price to pay for escaping quarterly earnings based testing. If your business shrinks, the available funding will shrink to fit, but you won't breach a covenant.
Author: Steve Smith, Partner
