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hello everyone welcome back to another video today we're gonna be covering asset based lending now asset based lending our loans made to businesses backed by a liquid asset used as collateral for the loan businesses that use a BLS are either highly leveraged or too small to take on more Bank debt and must resort to alternative lending solutions these loans are used to increase the working capital of a business in order to help finance growth or operating activities now some common industries that use a BLS are the steel retail and transportation industries and the reason is they are very cyclical businesses when the economy is performing very well inventory is low and the length of accounts receivable outstanding the day's outstanding for these credit accounts are much shorter whereas when the economy is performing poorly inventory stocks up accounts receivable the length outstanding the days of standing extends and increases and therefore the business is limited limited from a cash perspective from a working capital perspective now it's important to define what working capital is working capital is the capital a business uses in its day-to-day operations calculated as current assets minus current liabilities now a common problem is that some businesses face working capital restrictions or essentially means that they don't have enough cash to support their day-to-day business if they sell products and services to customers on credit meaning that there is an account receivable they will be waiting for that cash to come in or if that business has a lot of inventory it needs to sell this product first before it can actually receive the cash used to pay employees use to pay the bills to support that business and this is a real problem so this is not a long-term loan a BLS are not used to finance long term operations essentially they're used to support the day-to-day operations and they're closed out usually within a 12 month period now what are the key drivers of asset based lending well ASSA based loans can be categorized into four different segments there can be performance drivers which essentially means the industry is performing fairly poorly and therefore that business needs more financing to support their working capital there can be growth drivers which your Sunstream means the business is growing it's growing very very fast and it's actually exceeding its ability to finance its own growth and therefore the company seeks additional financing in order to support that additional growth whether it's through working capital needs or capital expenditure needs it can also be expansion through M&A and capital market drivers which essentially means paying stock a stock stock dividends actual dividends or it can actually refinance different upcoming debt maturities so there are a lot of drivers behind asset based lending it's not just that the business needs cash so there are a lot of strategic considerations when it comes to the lender and how they view the borrower and so we'll go into that so what abl is offer is a way to finance the business's day-to-day needs by taking out a loan on these accounts receivable or inventory which allows owners to pay for expenses while the receivables are collected or inventory is sold off there are three common abl structures there's the recourse and non recourse financing structure there is the purchase order financing structure and the inventory financing structure and so we'll go into each of these so recourse and non recourse financing before we actually understand how the NAB L is structured let's actually define what a recourse loan is a recourse loan is where the lender is able to seek financial damages to be paid back in full if the borrower defaults on their loan the liability is on the borrower as they have to find a way to pay back the loan in full so even if the value of the loans collateral declines the lender can ask for more assets in order to be paid back in full so a loan can either be recourse or non recourse with a recourse loan if you default even the collateral that you put up against that loan if it does not cover the financial liability the amount that you have to pay back to the lender the lender can then go and ask for more assets in order to be paid back in full now a non-recourse loan is where the loan is secured by collateral however if a borrower defaults the issuer can seize the collateral but cannot seek out the borrower for further compensation so the liability is on the lender as they would lose money if the collateral does not make up the entire value of the financial liability so with regards to a BLS a recourse financing agreement would advance funds up to ninety percent of eligible receivables which essentially are within 90 days or less and then once that account receivable has been collected the lenders pay back the difference net a fee for the service in a non-recourse agreement because the lender is taking on more risk because essentially if the business is only putting up their account receivable as collateral if that account receivable doesn't go through the borrower can just default on that loan and the lender only has the account receivable as collateral they cannot collect on anything else so in a non-recourse agreement because the lender is taking on more risk the advance is between 70 and 80 percent so it's less than recourse financing agreement for the same eligible receivables value so once the account receivable has collected the lender pays back the difference net Amite much higher fee so there are higher fees for recourse agreements in order to compensate for that risk of course so let's actually go into an example so consider a company that has a $1,000 account receivable the lender charges a 5% fee for the recourse agreement while they charge a 15% fee for a non-recourse agreement based on advance of funds so with a recourse financing structure the average is around 90% as we said in advance so we take that and we find it so this is a recourse financing agreement we give that that account receivable directly to the lender and so from now on the customer that needs to pay that account receivable will pay directly to the lender instead of us so that $1,000 90 percent of that is advanced to us so we received $900 today 20 days later when the customer finally pays back that bill the lender will calculate their fee based on the advance value so not $900 times 5 which is $45 so the remaining $100 they deduct a $45 fee and the remaining amount of $55 is given back to us so we receive a certain amount of that today and then we received a little rebate at the end net of fees so with a non-recourse you'll see that the fees are larger so in this case the advance is less and percentage-wise 70% so we receive only $700 and that could be of course because the account receivable is risky or that's just the way we pursue it and so 20 days later the customer pays back the account receivable and so if fee is charged on that $700 of 15% so the fee is a hundred and five dollars so the $300 that was the difference between what we received now and what we will receive later a hundred and five dollars is deducted away and we receive one hundred ninety five dollars twenty days later once the account receivable has been paid in full so that's how the recourse of non recourse financing agreements work okay now purchase order financing in a scenario where the company has received a large order and does not have enough cash available to cover the cost of production it can pursue the purchase order financing option this allows businesses to use their confirmed customer backlog and invoices to get an advance on their credit in order to increase working capital so the borrower accepts the invoice for the sale of their good or service and passes it along to the lender who collects on the invoice in return a certain percentage of the sale is advanced to the borrower once the sale is completed and the payment is received by the lender the difference between the advance and the sale price is returned net of fees so really it's quite similar so in this case we have an account receivable as well we have a backlog but the thing is here we need money in order to fulfill that backlog in order to complete that production that producing those goods in order to complete that sale so what we do is we go to the lender to get the necessary money in order to complete that sale whereas with the recourse and non recourse financing agreement the sale has already been completed and we're just waiting for payment from the customer so that's the difference between purchase order and recourse and non-recourse financing okay so the advance is dependent and this is key on the certainty of payment by the customer not the borrower so really when the lender is looking at that backlog they're analyzing will the customers back out and not really pay the full fee or will not be able to pay that or will they be able so there's a lot more focus on the on the customer rather than the borrower in the purchase order financing agreement with the account receivable it's much more it's much more balanced because at the same time with recourse and non-recourse financing you have to analyze the borrower's accounts receivable management strategy and at the same time still the customer who will be paying that account receivable so the the focus is much more split with recourse and non recourse whereas with purchase order it's much more emphasized on the customer so a safe customer could result in a 90 percent advance while a riskier one could mean an advance of 70 to 80 percent of the order backlog of value now let's look at an example having recently bought out one of my partners or one of his partners the businesses has only $1,000 in cash so their working capital is $1,000 there was a recent request a recent order for $10,000 worth of chairs the cost of production although the labor and materials is $9,000 the owner decides to pursue a purchase order agreement which charges fees of 7% on the advanced funds so in this case because it's considered a safe customer who is able to fulfill that payment of that of that sale the advance is 90 percent of the backlog value so in this case is $10,000 times 90 percent so we receive today as the business owner $9,000 now six weeks later we complete the production of the chairs and complete the sale and the customer pays so when that payment goes through which goes directly to the lender not us because now they have that account receivable there is a fee of seven percent deducted from the ninth dollars of 630 dollars and so the difference between what was advanced and what was the actual sale of $10,000 which is $1,000 we subtracted the fees from that difference and the net result of $370 is given back to us after six weeks that's how a purchase order looks finally inventory financing now inventory financing is a form of ABL where a business can leverage its inventory inventory financing is especially useful for businesses that must pay their suppliers in a shorter period of time than it takes them to sell their inventory to customers it also provides a solution for seasonal fluctuations and cash flows and can help a business achieve a higher sales volume for example by allowing a business to acquire extra inventory to sell during the holiday season and so let's look at the processes the first and then I'll actually explain these benefits so funds are drawn from inventory as it accumulates which is the value of that inventory and are paid then back once inventory is sold off as a finished product to clients so as inventory builds up our line of credit the amount of funds available that we can really draw on inventory financing increases now usually inventory financing is used in combination with an invoice factoring facility and so when we begin to sell that inventory we have to pay down the amount that we took out that line of credit as we sell that money goes to pay down that line of credit right away so there's a lot of limitations in that sense there's a lot of priorities so the priorities to pay down the line of credit before we can actually go to paying our bills okay now with invoice factoring with the invoice factoring facility this means that once a sale of inventory is complete that invoice is received and is financed through a factoring line and the proceeds are used right away to close the corresponding inventory line of credit from that point on the transaction is a factoring transaction where the customer pays their bill on schedule and the borrower is rebated the remaining amount so I won't spend too much time on that can actually look that up separately invoice factoring but essentially when invoice factoring is the business has the ability to take an invoice give it to a lender and tell them okay advance us the amount that we should be receiving from our client net fees of course and once the client pays that money back in full we receive the remaining amount net of fees okay so it's similar to what we've already talked about with recourse and non recourse financing and I think an example would be better now the advance is usually 80% of the inventories net orderly liquidation value or the for sale liquidation value and these are lower than market value and sometimes even substantially lower so that's one of the downsides to it now consider a situation where the day's inventory outstanding the DAO ratio which is the average number of days that it takes to sell inventory is 50 days if we have $100,000 in inventory and and have a bill of $80,000 do in 20 days we won't have enough time to sell that inventory because it'll take 50 days to sell all of our inventory to pay a bill in 20 days and so this is an ideal situation where inventory financing can be used so if I have $100,000 which is the liquidation value by the way and I have that $80,000 bill I can finance my inventory and so usually it's about 80% of the order net orderly liquidation value so 80% of $100,000 is $80,000 and we can take that money right away and pay the bill in 20 days when we need to now let us assume that I sell the inventory for 120,000 dollars which is the market value of that inventory and expect to be paid in four equal installments so the way the process works is I receive that advance on on the inventory the inventory still remains with me the the lender doesn't receive that inventory what I have to do is sell that inventory and as I sell it and realize the monetary value the cash value of that of that inventory I then begin to pay down my debt so in a very very easy example if I were to sell all of this inventory for $120,000 I then take that take that invoice which I received from the customer who will pay me and for equal installments I now then factor that invoice we talked about that this is the invoice factoring facility so taking the invoice I put it into the invoice factoring facility so I received the customer invoice which is Finance of the factoring line and usually that the the lender finances 80 to 90 percent of that value so assuming eighty percent eighty percent of the 120 thousand dollars that we should receive from the client is ninety six thousand dollars I take that money which I now have upfront I can then pay the advance that I received from the line of credit for my inventory and from then on so now I use this to pay down the inventory line of credit plus fees and then wait for the client to pay the invoice which the lender collects on once the 120 thousand dollars is paid in full and received by the lender the difference of twenty four thousand dollars which is the difference between 120 thousand and ninety six thousand would be rebated less more fees for the invoice factoring service so this is it seems confusing and this is why if you've done any additional research many many people say inventory financing should be your last alternative when considering other ABL options because this joint double fee system can become very very costly so once again let me explain it I have inventory of a hundred thousand dollars I need to pay a bill in eat in 20 days for eighty thousand dollars so I received an advance of eighty thousand to pay the bill now if I were to sell that inventory for 1
0 thousand I now have an account receivable of 120 thousand I don't receive the cash right away majority of the industries you have an account account you'll receive that on account on an account receivable and you will receive will have to wait for that customer to pay you back in in this case four times for the full 120 thousand dollar amount so what I can do in order to quickly pay down that line of credit is factor that invoice so I receive an advance of ninety six thousand dollars which is 80 percent of that invoice and I take that money Netta fees and pay down the line of credit of 80 thousand dollars now the account receivable is actually on the inventory line right so now what I can essentially I wait for the customer to pay back the full amount to pay me the full amount essentially which is received by the lender and once the lender deducts their fees I am rebated a certain amount of that $24,000 difference that's inventory financing it's a little confusing if you have any questions please do comment below but as you can see it's very complicated and can become very costly so as you can see the inventory financing option can be costly you will pay several different fee charges and with different interest rates are ranging between 4 to 6% plus the prime rate it can be very very costly another consideration is the cost of holding that inventory so that inventory is not just gonna stay at home it you're gonna have to put in a warehouse you're gonna have to take care of it security electricity for the warehouse everything so how much would it cost to wait and sell off the inventory in order to pay down that line of credit so among the three options presented inventory financing is usually the least favorable because sometimes the only but is sometimes the only ABL option available for some businesses especially retail businesses now the cost in time of due diligence by the lender to learn about your inventory can be demanding and audits of these holdings occur every three to six months the benefit of course is that you can accumulate inventory as your business grows to meet increased seasonal demand in addition the interest rates are usually lower than high-yield debt and so let me provide a positive example with regards to inventory financing so in a scenario where you recognize that right now we're in June and in December I'm gonna have a big holiday season and I need as much inventory as I can now I know that I'm at capacity for production so I should be storing up inventory but the thing is if I begin to store up inventory then I don't make any more sales and therefore there's not enough cash coming into the business to pay for you know the working capital for the bills for all the costs of labor for electricity for my wage as well to support my own family so what do I do well I can take out an inventory financing and delay the sale of that inventory and use the advance to pay my bills and so once I get into the holiday season I can then sell that inventory for probably more because it's in high demand market payback that line of credit and realize a higher profit so in that situation if you really are confident that there's gonna be strong demand later on you can delay the sale of your inventory by using inventory financing now there are several other challenges and as you can see there's more challenges than benefits to inventory financing and that's why it's considered the last alternative now interest rates are usually higher than bank debt there are also tight restrictions on borrowing and your business the day's inventory outstanding ratio the amount of days that it takes to sell your inventory needs to be small so if you have a high high ratio what happens is that it takes longer and longer to sell that inventory and therefore you really are stuck with inventory that is a huge risk because if you can't sell that inventory then you can't convert it into cash and therefore you can't pay down that line of credit so if the business has a high di o ratio then it's a significant risk if sales fall due to weaker demand all of a sudden the value of that inventory declines and the interest charge on that loan can limit future production so in a scenario where we can offload that inventory and therefore pay down the line of credit those high interest rates will really eat into our remaining working capital in the cash advance that we received on that line of credit and therefore we could be put into a position or we could go into default and risk default so that's why there's a lot of risks and if you take out inventory financing and the market goes against steel you can really get hurt and and your business can risk going into default so I wanted to make a separate comment on just asset based lending when a company takes out a ABL management is under the distant supervision of the lender who continues to review the account receivable cycle of the business in many ways small businesses become more organized and focused on improving the management of working capital in the face of an lb abl agreement their overall goal is to collect the receivables and sell inventory faster to free up cash for future expenses and pay down the abl from the businesses perspective this goal is Reard reiterated by the lender so really the lender and business are working towards the same goal the lender doesn't want you to default so that they take on that inventory because if he default they probably the business probably defaulted because that inventory was not able to be sold and therefore the lender would lose in that scenario so they'll both the lender and business are working towards a win-win situation and most times for young businesses that have taken out their first business loan an ABL can really help them mature as a company in order to manage their receivables better and understand the value of their inventory now from the borrower perspective there are three key ratios to consider when analyzing the borrower in order to understand their working capital management ability we talked about the day's inventory outstanding ratio which is essentially calculated by taking the current asset of inventory so inventory divided by cost of goods sold times 365 days which is the cycle of the accounting year now two other ratios are the day sales outstanding ratio which is essentially the flank the amount of time it takes to convert all of your accounts receivable into cash and so you divide the accounts receivable in the amount of accounts receivable in the calendar year or in a quarter in that respective quarter by the revenue in that quarter or were in this case it'd be the annual accounts receivable divided by annual revenues to get 365 and four days payable standing that is essentially the length of time it takes to pay outstanding accounts so from the business they might have accounts payable that they're they need to pay their suppliers how long does it take for us to pay our suppliers and so you divide a counselor payable by cogs and multiply that by 365 days now taking these three ratios so we then can use these three ratios to calculate the cash conversion cycle ratio the CCC ratio now which helps determine the efficiency of the company's working capital strategy so the CCC ratio is essentially the day sales outstanding ratio plus the days inventory outstanding ratio so the amount that it takes us to convert our current assets less the amount it takes us to convert or to pay down our current liabilities so DSO + di o- dpo by calculating comparing these ratios over the lifetime of the business the lender is able to understand if the business is capable of managing its working capital and how risky it would be to lend them money so the higher the CCC ratio is the more inefficient the businesses and managing its working capital the lower it is the quicker they they are able to really convert on their current assets so in conclusion the ABL is a strategic alternative lending solution for small to medium-sized businesses who face working capital challenges whether they are highly leveraged or too small for larger lenders ie the banks these businesses have a financing gap that asset-based lenders target while solutions like inventory financing can be costly usually the cost of an ABL facility is cheaper than high-yield debt or mezzanine financing and I've made a separate video on that and one of the big things with them is that there are equity kickers in those mezzanine of financing agreements such as warrants which compensate investors for that increased risk those equity kickers can dilute the existing shareholders of the business and therefore impact the amount of profit that you as the owner receive at the end of the year so an ABL can be used strategically to actually benefit you in certain situations other than that that's pretty much it for this video if you have any questions please like and subscribe to the channel for more and please do comment below if you are have any questions other than that thank you so much guys for watching and have a great day thank you
