The Dangers of Asset Based Loans For Small and Independent Retailers

The fact is that many small and independent retailers struggle with cash flow. Seasonal retailers in particular are confronted with the challenge of stretching their cash through slow periods, and then having the cash to build fresh stocks leading back into their busiest periods.

As a result, many small retailers find themselves having to finance these seasonal cash needs, in the form of a line of credit, and having to secure the loan with collateral in order to obtain this financing. In most cases the lender will require a personal guarantee from the borrower, but they will also require tangible assets be pledged as collateral. For most retailers, inventory is the only tangible asset significant enough to secure a line of credit.

These types of loans are frequently called asset based loans. Most small retail loans are asset based, secured by inventory. (There are some retailers, primarily businesses that are a mix of retail and wholesale, that may carry significant accounts receivable balances, and in those cases the accounts receivables may also be used to secure the loan.)

In very simple terms, here’s how most asset based loans work for retailers. The lender (often with the assistance of an inventory appraisal firm) will evaluate the quantity and quality of the inventory. The question they are seeking to answer, at its most fundamental is, “If I had to call this loan, and liquidate the collateral, how much could I get for the inventory in a liquidation sale?” (This often infuriates a retailer seeking a larger line of credit. “My inventory is worth a lot more than that! Why are they valuing my inventory based on liquidating it? I’m not going out of business!!”)

To do this, the lender will segregate the inventory to exclude items or categories they don’t want to collateralize, set aside any additional dollar reserves and arrive at what is called an advance rate. An advance rate is the percentage of the cost value of the inventory that the lender will lend. As such, once the advance rate has been set, the amount that may be outstanding on the loan at any given time will vary with the amount of inventory on hand.

(After the lender has arrived at the advance rate, they may further cap the outstanding balance on the loan in order to limit their exposure. In addition, they will likely impose a set of financial covenants that the retailer must meet.)

For lenders, collateralizing the inventory secures the loan, but for retailers these loans create a perverse set of incentives, incentives that are often at odds with prudent management decisions. Clearly, a retailer applying for an asset based loan requires a cash infusion. It’s possible that they are short on cash due to ill advised capital expenditures or cash withdrawals from the business. More likely, it’s because inventory has built up, (meaning that some portion is excess inventory) and is tying up valuable cash. Rather than serving to encourage the retailer to address their seasonal cash requirements by tightening up inventories and freeing up that cash, an asset based loan can actually exacerbate the problem, and further weaken the retailer.

For a cash-strapped retailer, an asset based loan looks like the way to go because it is a way to immediately generate much-needed cash. Once in place however, an asset based loan often leads to a problematic mindset; “The more inventory I have, the more I can borrow, and the more I can borrow, the more cash I have.” Even worse, it can leave a retailer that’s fully drawn in a real bind; “I have to keep my inventory high (and run up my payables if necessary) or I’m going to have to pay down my outstanding balance with cash I don’t have.” At its most insidious, an asset based loan can actually lead a retailer to decide not to address the very situation that has created the problem in the first place.

For these reasons, the imperative for most small and independent retailers is to self finance as much of their seasonal cash needs as possible. The cash flow generated from each season needs to be used to internally finance the next season’s purchases rather than pay off the loans that financed the previous season’s purchases.

This is where a cash flow plan can really help alter the basic financial structure of the business. It won’t happen overnight, but if each season is planned to continually increase the ending cash flow balance, that will leave an ever increasing amount of cash available to self-finance the next season, incrementally reducing the amount that needs to be borrowed, until, in the best case scenario, the business ultimately is able to completely self finance it’s seasonal cash needs. If unavoidable, an asset based loan should be narrowly viewed as providing a short-term window of opportunity to finally get your financial structure back on a sustainable footing.

All too often, an asset based loan may not start you on a downward spiral, but it certainly can exacerbate it by leading you to take your eye off the real work that needs to be done, to correct the problems that have led to the cash flow crunch in the first place. It’s one thing to have a line of credit available if you need it, but it’s another thing entirely if you find yourself relying on it.

An asset based loan may make sense if you are looking to invest the proceeds in a way that will genuinely grow your revenues. If however, like many small and independent retailers, you find yourself considering an asset based loan to finance your seasonal cash needs it should be a wake-up call that you have serious work to do on your cash flow.