Cash flow lending vs. Asset-based lending

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Cash Flow Lending Vs. Asset-Based Lending

Whether a company is a startup or a 200-year-old conglomerate like EI du pont de nemours and company (DD), it relies on debt capital to operate the way a car runs on gasoline. ..

When a company borrows money from a bank or other institution to finance its operations, acquire another company, or make another major purchase, it will likely fund the loan through one of two primary lending methods: cash flow-based lending allows individuals or businesses to borrow money based on a company's projected future cash flows, while asset-based lending allows them to borrow money based on the liquidation value of assets on their balance sheet. (for more information, see: how advisors can help clients with cash flow problems.)

We look at cash-flow-based lending and asset-based lending, the advantages and disadvantages of both options, and the scenarios in which one method is the preferred one. (for more information, see: what's the difference between active lending and asset financing?)

Cash flow lending

In cash flow lending, a financial institution makes a loan that is funded by the personal or cash flows. By definition, this means that a company borrows money from the revenue it expects to receive in the future. Credit ratings are far more important in this form of lending, along with historical cash flows.

For example, a company trying to meet its payroll obligations could use cash flow financing to pay its employees now and pay the loan and any interest on the employees' profits and earnings on a future date. These loans do not require any type of physical collateral such as property or assets. Instead, these lenders look at expected future business income, creditworthiness and enterprise value.

The advantage of this method is that a company can obtain financing more quickly because an appraisal of collateral is not required.

Institutions distinguish cash flow-based loans by determining creditworthiness. Typically, they will use EBITDA (a company's earnings before interest, taxes, depreciation and amortization) along with a credit multiple to calculate this number. This method of financing allows lenders to take into account any risk caused by sector and economic cycles. During an economic downturn, many companies will experience a decrease in their EBITDA, while the risk multiplier used by the bank will also decrease. The combination of these two declining figures will reduce the available lending capacity for an organization.

Cash flow loans are better suited for companies that hold high margins on their balance sheets or do not have enough in hard assets to offer as collateral.

Companies that meet these qualities are service providers, marketers, and manufacturers of low-margin products. Interest rates on these loans are usually higher than the alternative due to the lack of physical collateral that the lender can obtain in case of default.

Asset based lending

Asset-based lending involves business loans secured by the liquidation value of their assets. A recipient obtains this form of financing by offering as collateral inventory, receivables, and/or other balance sheet assets. While cash flows (especially those tied to physical assets) are considered in providing this loan, they are secondary as a determining factor.

Common assets provided as collateral for a capital loan include physical assets such as real estate such as land and physical property, inventory, and manufacturing equipment or physical goods. If the borrower fails to repay the loan or defaults, the lending bank can seize the collateral and sell the assets to recover its loan amount.

Asset-based lending better suited for companies with large balance sheets and lower EBITDA margins. They are also companies that need capital to operate and grow, especially in industries that may not offer significant cash flow potential. An asset-based loan can provide a company with the capital it needs to cope with the lack of rapid growth.

Depending on a company's creditworthiness, they may be able to borrow between 75% and 90% of the face value of their receivable position on the balance sheet. Companies with weaker credit ratings might make as little as 60% to 75% of that face value, according to authors william bygrave and andrew zacharakis. However, when providing physical inventory or production equipment as potential collateral, the loan amount may be less than 50% of the perceived value of the assets. The reason is that these assets could be sold through liquidation or auction and the lender may need to sell these assets quickly to get repaid.

Asset-based loans have very strict rules regarding the collateral status of the physical assets used to obtain a loan. Most importantly, no company or individual may offer these assets as a form or as collateral for other lenders. If these assets are pledged to another lender, that former lender must subordinate its position in order to receive the assets. Finally, the company receiving the loan must handle any accounting, tax, or legal matters prior to an agreement being reached. Such concerns could affect the lender's ability to secure and sell the asset in liquidation.

Before approving a loan, lenders require a relatively lengthy due diligence process that includes reviewing a company's balance sheet, accounting records and assets to calculate the value of its allowable borrowing capacity. Costs associated with this analysis vary, but common costs include site visits, collateral evaluations, and interest charges.

The bottom line

When a business or individual needs a loan to conduct short-term or long-term business, they have two primary options for borrowing money. These two types of loans have a variety of different qualities. Cashflow lending has a stronger emphasis on the creditworthiness of an individual or organization and expected deposits to the balance sheet. Meanwhile, investors with lower cash flows, weaker credit ratings or solid receivable positions on their balance sheets could obtain financing through an asset-based loan. However, the asset values usually need to be of significant value for a lender to take the risk.