# Asset-Based Lending: Definition, How It Works, and Examples

## What Is Asset-Based Lending?

Asset-based lending involves securing loans with collateral, such as inventory or equipment, to meet business cash flow demands. This form of lending provides short-term liquidity by using assets as a line of credit. Companies that cannot demonstrate sufficient cash flow may leverage their existing assets to gain financial flexibility.

### Key Takeaways

*   Asset-based lending is a business financing method where loans are secured by the borrower's assets, such as inventory, accounts receivable, or equipment.
*   This type of financing is primarily used by small to mid-sized businesses to meet temporary cash flow needs.
*   Lenders prefer highly liquid collateral, which can be easily converted to cash, reducing the risk of the loan.
*   Loans secured by physical assets are often perceived as riskier, resulting in a lower loan amount compared to the asset's book value.
*   Interest rates for asset-based loans are generally lower than those for unsecured loans due to the reduced risk for lenders.

## Understanding the Mechanics of Asset-Based Lending

Many businesses need loans or credit lines to handle regular cash flow needs. For instance, a business might get a credit line to cover payroll if payment delays occur.

If a company can't prove enough cash flow or assets for a loan, lenders might accept [physical assets as collateral](https://www.investopedia.com/terms/b/borrowing-base.asp). For example, a new restaurant might be able to obtain a loan only by using its equipment as collateral. Lenders might require a [negative pledge clause or covenant](https://www.investopedia.com/terms/n/negativepledgeclause.asp) as part of the loan. This clause will limit the borrower from reusing the pledged asset for another loan.

The terms of an asset-based loan depend on the type and value of the assets used as security. Lenders prefer highly liquid collateral, such as securities, that can readily be converted to cash if the borrower defaults on the payments. Loans secured by physical assets are considered riskier, so the maximum loan amount will be considerably less than the book value of the assets. Interest rates vary based on the borrower's credit history, cash flow, and business longevity.

> **Important**
>
> Interest rates on asset-based lending are lower than rates on unsecured loans since the lender can recoup most or all of its losses in the event that the borrower defaults.

## Example of Asset-Based Lending

For example, say a company seeks a $200,000 loan to expand its operations. If the company pledges the highly liquid [marketable securities](https://www.investopedia.com/terms/m/marketablesecurities.asp) on its balance sheet as collateral, the lender may grant a loan equalling 85% of the face value of the securities. If the firm’s securities are valued at $200,000, the lender will be willing to loan $170,000. If the company chooses to pledge less liquid assets, such as real estate or equipment, it may only be offered 50% of its required financing, or $100,000.

In both cases, the discount represents the costs of converting the collateral to cash and its potential loss in [market value](https://www.investopedia.com/terms/m/marketvalue.asp).

## Important Considerations for Asset-Based Borrowers

Small and mid-sized companies that are stable and that have physical assets of value are the most common asset-based borrowers.

However, even large corporations may occasionally seek asset-based loans to cover short-term needs. Issuing more shares or bonds can be costly and take too long. The cash demand may be extremely time-sensitive, such as in the case of a major acquisition or an unexpected equipment purchase.

## The Bottom Line

Asset-based lending provides businesses, particularly small to mid-sized ones, with essential access to capital through loans secured by collateral assets. This method is particularly useful for companies that need to meet short-term cash flow needs but may not have sufficient cash flow or credit to secure traditional loans. By leveraging physical or liquid assets such as inventory or accounts receivable, businesses can obtain vital funding while lenders manage their risk through collateral.

However, it is crucial for businesses to consider the type of assets pledged, as highly liquid assets are preferred and can influence loan terms. While asset-based loans are less risky for lenders and come with lower interest rates than unsecured loans, businesses should be aware of potential limitations on their pledged assets and the terms associated with these loans to ensure sound financial decision-making.