Short-term funding sources - Asset-backed lending and securi...

Learning Outcomes

This article addresses the core principles of short-term finance using asset-backed lending and securitisation for the ACCA Advanced Financial Management exam. You will learn how companies use assets like receivables or inventory to raise funds, how securitisation allows pooling and selling of these assets to investors, and the key risks and benefits involved. By the end, you should be able to identify, explain, and evaluate asset-backed funding options.

ACCA Advanced Financial Management (AFM) Syllabus

For ACCA Advanced Financial Management (AFM), you are required to understand the use and implications of asset-backed lending and securitisation as sources of short-term finance. Revision in this area should focus on:

• Identifying and describing the use of asset-backed lending (such as factoring, invoice discounting, inventory finance)
• Explaining the securitisation process, including the creation of special purpose vehicles (SPVs) and the pooling of financial assets
• Assessing the impact, risks, and benefits of asset-backed lending and securitisation for liquidity management and financial strategy
• Evaluating the effect of these funding methods on risk exposure, financial statements, and creditworthiness
• Analysing why and how such instruments are used by corporates in comparison with traditional bank finance

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following best describes securitisation?
   1. Borrowing funds directly from a bank
   2. Converting financial assets into tradable securities via an SPV
   3. Financing inventory using supplier credit
   4. Issuing shares to raise equity
2. Asset-backed lending typically involves which of the following types of assets?
   1. Intangible fixed assets
   2. Cash and cash equivalents
   3. Accounts receivable and inventory
   4. Deferred tax assets

3. True or false? Factoring is a form of asset-backed lending that may transfer credit risk to the lender.

4. List two main risks to a company when using securitisation for funding.

Introduction

Efficient management of short-term funding is critical for businesses seeking liquidity without overreliance on traditional bank debt. Two important sources are asset-backed lending and securitisation. Both approaches enable companies to access finance by utilising existing assets, such as trade receivables or inventory. By understanding how these mechanisms work, their advantages, and their risks, you can make informed recommendations within the context of the ACCA AFM exam.

ASSET-BACKED LENDING

Asset-backed lending is short-term financing secured against specific company assets. It provides access to funds that might not be available through unsecured loans, as the lender takes security over the assets offered. Common facilities include factoring, invoice discounting, and inventory finance.

Key Term: asset-backed lending
A form of financing where a company borrows against the value of specific assets (e.g., receivables, inventory), with the assets serving as collateral for the loan.

Factoring and Invoice Discounting

Factoring is where a business sells its trade receivables to a third party (the factor) at a discount, receiving immediate cash. The factor may also take on the role of collecting receivables and managing the sales ledger, and can assume the risk of customer default (non-recourse factoring).

Invoice discounting, meanwhile, involves using unpaid invoices as collateral for borrowing, but the borrower retains responsibility for collections and credit risk.

Key Term: factoring
The process of selling accounts receivable to a third-party factor, who provides immediate cash and may take on credit collection duties and certain risks.

Key Term: invoice discounting
A facility where a company borrows funds secured by its outstanding receivables, but retains control of the sales ledger and collection processes.

Inventory (Stock) Finance

Inventory finance involves raising funds using stock as collateral. This is suitable for businesses holding significant inventory balances for sale or production. Lenders typically retain title over the inventory, releasing cash as the value of inventory is confirmed.

Key Term: inventory finance
A type of asset-backed loan where funds are advanced to a company secured by the value of its inventory or stock.

Advantages and Disadvantages

Advantages:

• Immediate release of working capital tied up in receivables or inventory
• Funding linked to sales growth (as receivables or inventory increase)
• May be available to firms with low or variable credit ratings if the collateral assets are strong

Disadvantages:

• Potentially higher costs than traditional lending
• Lender may impose restrictive covenants or require strict reporting
• Reliance on quality and liquidity of the collateral assets

SECURITISATION BASICS

Securitisation is a structured process that allows companies to convert pools of illiquid assets, such as receivables, into tradable securities that can be sold to investors. This process is commonly used by financial institutions but is increasingly adopted by corporates.

Key Term: securitisation
The process of pooling financial assets and selling them to a special purpose vehicle (SPV), which funds the purchase by issuing securities to investors.

Key Term: special purpose vehicle (SPV)
A separate legal entity created to isolate financial risk, used to purchase assets from the originator and issue securities to investors.

Steps in Securitisation

1. Asset Pooling: The company (originator) bundles similar financial assets, such as trade receivables, loans, or lease payments.
2. Transfer to SPV: Assets are sold to an SPV, ensuring they are separated legally from the originator’s balance sheet.
3. Issuance of Securities: The SPV issues debt securities (such as asset-backed securities, ABS) to investors, using the cash flows from the pooled assets to pay interest and principal.
4. Servicing: The originator or a third party may continue to service (collect payments on) the assets, but investors take on much of the risk and reward.

Key Term: asset-backed security (ABS)
A bond or note issued by an SPV, backed by cash flows from pooled financial assets.

Benefits and Risks

Potential Benefits:

• May reduce the originator's funding costs compared to unsecured loans
• Off-balance sheet treatment (subject to accounting standards), improving gearing ratios
• Transfers credit risk to investors
• Facilitates liquidity and access to broader capital markets

Risks:

• Structural complexity increases operational and legal risks
• Residual risks may remain with the originator, especially with partial recourse arrangements
• Mispricing or lower asset quality can lead to investor losses and reputational damage (as seen in past financial crises)

Worked Example 1.1

A manufacturing company has a portfolio of $50m trade receivables. It sells these receivables to an SPV, which issues $45m of securities to investors. The SPV uses collections from the receivables to pay interest to investors. What advantages and risks does this provide for the manufacturer, and for the investors?

Answer:
The manufacturer gains immediate liquidity ($45m cash), may record a reduced level of debt on its balance sheet, and transfers some credit risk. The risk is that if receivables default, the SPV (and investors) bear that risk if the structure is truly non-recourse. The manufacturer may still face reputational risk if asset performance is poor. Investors benefit from diversification, but face credit risk if receivable quality is below expectations or economic conditions deteriorate.

Exam Warning

Securitisation questions may test your ability to identify both benefits (liquidity, risk transfer) and major risks (reputational, residual credit risk, complexity) for all parties involved. Avoid assuming all risk is fully transferred unless the structure is described as non-recourse.

Revision Tip

Be prepared to calculate the maximum amount that can be raised through asset-backed lending (e.g., factoring facility or inventory finance), and to explain the effect of securitisation on financial ratios and credit risk.

Summary

Asset-backed lending and securitisation are advanced funding techniques allowing businesses to raise short-term finance using company assets as collateral or by transforming these assets into tradable securities. While both methods help improve liquidity and manage risk, each brings specific operational, legal, and credit risks. Understanding these processes is essential for advising on working capital strategy and for responding to case-based ACCA AFM exam questions.

Key Point Checklist

This article has covered the following key knowledge points:

• Identify the range of asset-backed lending options (factoring, invoice discounting, inventory finance)
• Explain how securitisation transforms financial assets into tradable securities via SPVs
• Distinguish between the roles and risk profiles of originators, SPVs, and investors in securitisation
• Assess the benefits and risks associated with asset-backed funding and securitisation
• Evaluate the impact of these short-term funding methods on liquidity, credit risk, and financial statements

Key Terms and Concepts

• asset-backed lending
• factoring
• invoice discounting
• inventory finance
• securitisation
• special purpose vehicle (SPV)
• asset-backed security (ABS)