Asset based financing is based upon collateralizing a loan with a certain asset or the cash flows from an asset like a receivable. Additionally, asset financing is used quite often to try and receive cash in the form of a loan. The investors in asset backed financing often have first claim over the assets.
Often times, companies have accounts receivable payments that they believe they will see in the future. If they believe that they will need financing soon they will use these future receivables and sell them off to investors. This allows the company to become more liquid by receiving a loan of cash up front rather than having to wait on the future receivables so that the company is able to meet its short term obligations. If the company were to default on this loan then the asset based lender could assume the future receivable payments to pay the loan. Another form of asset based lending is for a company to simply use an asset like equipment or land as collateral in order to obtain a loan. This occurs if a bank or other financial institution decides not to extend credit unless they have some sort of collateral.
Tiny Tots Inc. specializes in the manufacture of toys. Currently, the company wants to obtain financing so that it can expand its operations into South America. After visiting with the bank, the bank decides that it will provide financing. But the company must use asset backed financing and put its current production facility up as collateral. Tiny Tots agrees with this proposition and a contract is signed. After 5 years of production Tiny Tots has become very successful in South America. Tiny Tots pays off the loan, thereby freeing the production facility from the asset backed security. It should be noted that if the company had failed to make the interest and principal payments that the bank has the ability to take possession of the production facility. Then the bank will sell it to pay off the loan.
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