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Overview

Cash flow-based lending

Asset-Based Lending

Key differences

Business Loan Underwriting

Financial Lending FAQs

The Bottom Line

Corporate Finance Corporate Finance Fundamentals

Cash Flow and. Asset-Based Business Lending What’s the Difference?

By James Garrett Baldwin

Updated October 08, 2022

Read by Amy Drury

Cash Flow in comparison to. Asset-Based Business Lending A Comprehensive Overview

Whether a company is a new venture or an established conglomerate such as E. I. du Pont de Nemours and Company (DD) that relies on capital borrowed to run the way that an automobile runs on gasoline. Business organizations have different options in borrowing which can make business borrowing somewhat more complex than the standard personal borrowing choices.

Companies may choose to borrow money from banks or other institution to finance their operations, acquire another company, or engage in a major purchase. For these purposes, they may be possible to look at a variety of lenders and options. In a broad generalization the business loans as well as personal loans can be made either secured or unsecure. Financial institutions can provide a variety of lending options within the two categories that can be tailored to each individual borrower. Secured loans are not backed by collateral, while secured loans are.

In the secured loan category, businesses may identify cash flow or asset-based loans as a potential alternative. In this article, we will discuss the definitions and distinctions between them, and some scenarios on when one is more preferred to the other.

The most important takeaways

Both asset-based and cash flow-based loans are generally secured.

Cash flow-based loans consider a company’s cash flows when determining the loan terms while asset-based loans look at assets in the balance sheet.

Cash flow-based loans could be a better option for companies without assets like many service businesses or those with greater margins.

Asset-based loans tend to be more beneficial for businesses with strong balance sheets that might have smaller margins or unpredictable cash flow.

Asset-based and cash flow-based loans are good choices for businesses looking to efficiently reduce their credit costs, as they are typically secured loans which usually come with better credit terms.

Cash Lending

Cash flow-based loans allow companies to borrow money based on the projected the future flow of cash for their company. In cash flow lending, a financial institution grants an loan that is secured by the recipient’s past and projected cash flows. This means that a company borrows cash from the expected revenue they anticipate they will receive in the near future. Credit ratings are also used in this form of lending as an important criteria.

For instance, a firm that is attempting to meet its obligations regarding payroll could use cash flow finance to pay employees today and repay the loan and any interest on the earnings and profits generated by employees on an undetermined date. These loans do not require any type of physical collateral like assets or property but a portion or all of the cash flows that are used in the underwriting process are usually secured.

To guarantee cash flow loans, lenders examine projected future profits of the company and its credit rating and its enterprise value. The advantage of this method is that the company could get financing more quickly since the appraisal for collateral isn’t needed. Institutions typically underwrite cash flow-based loans with EBITDA (a company’s profits before tax, interest, depreciation and amortization) together with an increase in credit.

This method of financing allows banks to be aware of any risk caused by sector and economic cycles. During an economic downturn, many companies will see a decline in their EBITDA, while the risk multiplier utilized by the bank will also decrease. The combination of these two declines can affect the credit available to an organisation or raise interest rates if provisions are included to be dependent on these factors.

In the case of cash flow loans are best suited for businesses that have high margins or lack sufficient hard assets to offer as collateral. The companies that fit these requirements include service providers as well as marketing companies and manufacturers of low-cost products. The interest rates on these loans generally are higher than other loans due to the absence of physical collateral that could be secured by the lender in the case in default.

Both cash flow-based as well as asset-based loans are usually secured by the promise of assets or cash flow collateral in the loan bank.

Asset-Based Lending

Asset-based lending allows companies to take out loans based on the liquidation value of the assets they have on their balance sheets. A recipient receives this form of funding by offering accounts receivable, inventory and/or other balance sheet assets as collateral. While cash flows (particularly those tied to any physical assets) are considered when making this loan however, they’re not as important in determining the amount.

Common assets used to secure an asset-based loan comprise physical assets such as real estate, land, property such as inventory of companies, equipment, machinery, vehicles, or physical items. Receivables may also be considered as an asset-based loan. In general, if a borrower fails to repay the loan or defaults, the lender holds a lien on the collateral and can receive approval to levy and sell the collateral in order to recover the defaulted loan values.

Asset-based lending is better suited for organizations that have large balance sheets, and have lower EBITDA margins. It is also a good option for companies that require capital to run and expand especially in sectors which may not have a an abundance of cash flow. A asset-based loan can give a company the necessary capital to overcome the issue of slow growth.

As with other secured loans, loan to value is a factor when it comes to credit based on assets. A company’s credit quality and credit score will determine the loan to value they will receive. Typically, high credit quality firms can borrow from 75% to 90 percent of the value of their collateral assets. Businesses with less credit quality may only be able to borrow 50% to 75% of this face value.

Asset-based loans typically adhere to a strict set of rules about what constitutes collateral for the physical assets utilized to get a loan. Above all else, the company usually cannot provide these assets as a form of collateral to lenders. In certain instances there are instances where second loans to collateral are illegal.

Before authorizing an asset-based loan, lenders can require an extensive due diligence process. This process can consist of a thorough examination of accounting, tax, and legal aspects, as well as the analysis of financial statements as well as asset appraisals. Overall, the underwriting of the loan will determine its approval , as will the rates of interest and the allowable principal amount offered.

Receivables lending is a prime illustration of an asset-based loan which many businesses make use of. In receivables lending, companies is able to borrow funds against their receivables in order to bridge the gap between revenue recording and the receipt of funds. Receivables-based lending is generally an asset-based loan as receivables generally secured with collateral.

Some companies prefer to keep ownership over their assets, as opposed to selling them to raise capital. because of this, businesses are willing to pay a fee for interest to take loans on these properties.

Key Differences

There are ultimately several primary differences between these forms of lending. Financial institutions that are more interested in cash flow lending focus on the future of a business, while institutions issuing assets-based loans adopt a long-term view by prioritizing the balance sheet over the future income statements.

Cash flow-based loans do not require collateral. the basis of asset-based lending is having assets to be posted in order to limit risk. For this reason, companies may have difficulty to obtain cash flow-based loans since they need to make sure that working capital is appropriated specifically to the loan. Some companies simply won’t have sufficient margin capacity to accomplish this.

In addition, each kind of loan utilizes different metrics to assess qualification. Cash flows loans are more concerned with EBITDA which eliminates accounting impacts on income and concentrate on the net cash available. Alternatively the asset-based loans tend to be less focused on income; institutions will still monitor liquidity and solvency but have less requirements regarding operations.

Asset-Based Lending as opposed to. Cash Flow Based Lending

Asset-Based Lending

Based on the past process of how a firm has been able to make money previously

Use assets as collateral

May be easier to obtain because there are usually fewer operating covenants

Tracked using liquidity and solvency but is not as focussed on the future of operations

Cash flow-based lending

Based on the potential future of a company that earns money

Utilize future operating cash flow as collateral

May be more difficult to satisfy operating requirements

Utilizing profitability metrics to remove the non-cash accounting impact

Business Loan Options and Underwriting

Companies have a greater variety of borrowing options than private individuals. In the ever-growing field of online financing, new types of loans and loan options are being created to help provide new capital access options to all kinds of companies.

In general, the underwriting process for any type of loan will be heavily dependent on the borrower’s credit score and credit quality. While a borrower’s credit score is often a key aspect in lending approval, every lender on the market has their own set of underwriting standards to assess the credit quality of borrowers.

Comprehensively Unsecured loans of any kind could be harder to obtain and usually have greater interest rates relative to the amount due to the risks of default. Secured loans that are secured by any kind of collateral could reduce the risks of default for the underwriter , and therefore potentially lead to more favorable loan conditions for the customer. Cash flow-based and asset-based loans are two possible kinds of secured loans that a company can think about when seeking to identify the most advantageous loan terms for reducing credit costs.

Is Asset-Based Lending more beneficial than Cash Flow-Based Lending?

A particular type of financing isn’t necessarily better than the other. One is better suited for larger companies that can post collateral or operate on very tight margins. Another option may be better to be used by companies that do not possess assets (i.e. many service companies) but are confident in the future cash flow.

Why Do Lenders Look at the Cash Flow?

Creditors are interested in future cash flow as it is one of the best indicators of liquidity and also being able to repay the loan. Forecasts of future cash flows are an indicator of risk; businesses with a higher cash flow are simply less risky since they anticipate they’ll have the resources to meet liabilities as they become due.

What Are the Types of Asset-Based Loans?

Businesses may frequently pledge or use various types of collateral. This could include accounts receivables that are pending and inventory that is not sold manufacturing equipment, other long-term assets. Each of these groups will be classified with different levels of risk (i.e. receivables may be uncollectable, land assets may depreciate by value).

The Bottom Line

If you are trying to get capital, companies often have several options. Two such options are cash flow or asset-based financing. Companies with stronger balance sheets and larger assets in place may be more inclined to secure asset-based financing. However, businesses with better potential and less collateral might be better suited to cash flow-based financing.

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