Here's how a typical asset-based loan made against a company's receivables might work.
Step 1. The company sells its product or service to customers. Unless it's a cash-based business or a business where customers pay for all their purchases by credit card, a receivable is created. The receivable, really a debt owed to the company, is usually repaid in 10, 15, 30 or 45 days.
Step 2. The lender makes a loan to the company based on the value of the receivables, typically advancing 80 percent of eligible receivables. The moment the funds are advanced, the company starts paying interest on the loan.
Step 3. Customers are instructed to send their payments directly to the finance company.
Step 4. The lender remits to the company the invoice payments, less the principal on loans it has already advanced, less interest.
Step three can make borrowers queasy--and for good reason. After all, in any business, cash flow equals life, and placing your lifeblood under the control of a third party can bring risks. For instance, suppose a borrower has a large outstanding balance that's continuously revolving. Further suppose that an entire group of the borrower's customers had sold products to a region of the world which experienced a financial meltdown. The lender, who monitors the assets very closely and begins to see the length of these customers' receivables expanding, may take a "reserve" to protect itself. Instead of remitting customer payments to the company, the lender holds some of them as a reserve against future loan losses. Suddenly, the company doesn't have funds it may have been counting on.