Collateral assets fall into two primary categories identified as short and long-term holdings. Short-term holdings, such as cash, inventory, or accounts receivable are assets that are readily liquid. Long-term holdings, such as real estate, vehicles, equipment, investments, or intellectual property, often have less liquidity but more enduring value for a company as they’re large, expensive investments essential to doing business.
For collateral or asset-backed financing, lenders value an asset based on how easily and quickly the holding can be converted to cash if the borrower defaults on the loan. Short-term assets can be converted quickly. Converting long-term assets can take more time and rely on factors such as asset age, the current market, and how easily the asset can be sold or transferred.
An asset’s value to a lender dictates how much the lender will offer as a loan against that asset. Lenders may use a third party to appraise assets or criteria such as MAST (Marketable, Ascertainable, Stable, Transferrable):
Marketable – is there a secondary market for this asset?
Ascertainable – is the asset’s value easy to determine or is it subjective?
Stable – will the asset keep its value or depreciate in a predictable manner over the course of the loan? Will the value fluctuate?
Transferrable – is the asset easy or difficult to sell or transfer?
Lenders rank assets by their value to the lender, not to the business. The highest quality asset is cash, as it doesn’t need to be converted and can be used to directly pay a loan if the business defaults. For this reason, a lender may offer 95-100% of the cash value as a loan. Real estate is a popular collateral asset but may only secure a loan of 70-75% of its value. A business can also use accounts receivable or inventory as collateral. Typically, a lender will offer 60-70% of accounts receivable value and about 50-60% inventory value. Low-value assets would be things like aging machinery which is hard to sell or past due accounts receivable.
Lenders often tie the loan term to the type of asset. A lender is likely to prefer short-term holdings, such as cash, inventory, or accounts receivable, for a shorter-term loan—usually two years or less. This is lower risk for the lender, but higher risk for the business owner as more of the liquid assets are tied to the loan. For a medium-term loan of two to five years, a lender will usually prefer a longer-term holding, such as real estate, vehicles, or equipment,
For a longer-term loan of five years or more, the lender may prefer real estate. The longer the loan term, the less the loan is collateralized. This carries more risk for the lender, but less risk for a business owner as they have more time to pay the loan and clear any lien on the asset.
Corporate Finance: Collateral Quality: https://bit.ly/463dlhg
Fundera: 5 Types of Collateral: https://bit.ly/3p5IX5i
Nav.com: Understanding Business Loan Collateral: https://bit.ly/3JeFwA2