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

By James Garrett Baldwin

Updated October 08, 2022

Read by Amy Drury

Cash Flow and. Business Lending based on Assets A Comprehensive Overview

Whether a company is a start-up or a conglomerate with a history of 200 years like E. I. du Pont de Nemours and Company (DD) that relies on capital borrowed to run in the same way as an automobile runs on gasoline. Business organizations have choices over individuals when it comes to borrowing, which makes business borrowing somewhat more complex than personal borrowing options.

Companies may choose to borrow money from a bank or another institution to finance their operations, buy an additional company, or participate in a major transaction. To do these things it is possible to use a range of lenders and options. In general terms, business loans, like personal loans are made either unsecured or secured. Financial institutions are able to provide a variety of lending provisions within the two categories to accommodate each individual borrower. The unsecured loans are not backed by collateral, while secured loans are.

In the secured loan group, businesses could look at asset-based or cash flow loans as an option. In this article, we will discuss the definitions and distinctions between the two, as well as certain scenarios that show which is preferred over the other.

Important Takeaways

Both asset-based as well as cash flow-based loans are usually secured.

Cash flow-based loans focus on a company’s capital flows when determining the loan conditions, while asset-based loans take into account assets from the balance sheet.

Cash flow loans may be better for businesses that do not have assets, like many service businesses or for entities that have greater margins.

Asset-based loans are typically better for firms with solid balance sheets who might have smaller margins or unstable cash flow.

Cash flow-based as well as asset-based loans can be good options for companies looking to effectively reduce their credit costs, as they’re both secured loans which usually come with higher credit terms.

Cash Flow Lending

Cash flow-based lending permits companies to borrow money according to the forecasted the future flow of cash for the company. With cash flow lending the financial institution offers an loan that is backed by the beneficiary’s past and projected cash flows. This means that the company is borrowing money from expected revenues they anticipate receiving in the near future. Ratings on credit are utilized in this kind of lending to serve as an important criteria.

For instance, a firm which is trying to meet its obligations regarding payroll may use cash flow financing to pay its employees now and then pay back the loan and any interest on the earnings and profits generated by the employees on a future date. These loans are not backed by any kind of physical collateral such as assets or property, but some or all cash flows used for underwriting are typically secured.

To underwrite cash flow loans The lenders evaluate expected future company incomes as well as its credit score and also its value to the business. The advantage of this strategy is that companies can be able to obtain financing faster because appraisement of collateral is not required. The majority of institutions underwrite cash flow loans using EBITDA (a company’s profits before interest, taxes, depreciation and amortization) in conjunction with an increase in credit.

This financing method enables lenders to account for any risk brought on by sector and economic cycles. During an economic downturn the majority of companies will notice an increase in their EBITDA as well as the risk multiplier used by banks will also decrease. The combination of these two declining numbers can reduce the credit available to an organization or increase rates of interest if provisions are made to be based upon these parameters.

In the case of cash flow loans are best suited for firms that have high margins or do not have enough tangible assets to provide as collateral. Businesses that can meet these criteria include service firms, marketing firms, and manufacturers of low-cost products. Interest rates for these loans generally are more expensive than alternatives because there is no physical collateral that can be secured by the lender in the case of default.

Both cash flow-based and asset-based loans are typically secured by the promise of cash flow or asset collateral for the lender.

Asset-Based Lending

Asset-based lending allows businesses to borrow money by calculating the liquidation cost of their balance sheets. A person who is receiving this form of funding by offering accounts receivable, inventory or other balance sheet assets as collateral. Even though cash flows (particularly those tied to any physical assets) are taken into consideration when granting the loan, they are secondary as a factor determining the loan.

Common assets that are provided to secure an asset-based loan include physical assets like real estate, land, property, company inventory equipment, machinery vehicles, and physical items. Receivables can also be included as a form of asset-based lending. Overall, if the borrower fails to pay back the loan or defaults, the lending institution is able to levy the collateral and may be granted permission to levie and sell the collateral in order to recoup defaulted loan values.

Asset-based loans are better suited for companies with large balance sheets, and have lower EBITDA margins. This can also be good for businesses that need capital to operate and grow especially in sectors which may not have a significant cash flow potential. A asset-based loan can provide a company the needed capital to address its lack of rapid growth.

As with the majority of secured loans, loan to value is an important factor in credit based on assets. A company’s credit score and credit score will affect the loan rate they can receive. Typically, high credit quality companies can borrow anywhere from 75% to 90 percent of the face amount of the collateral they hold. Businesses with less credit quality might be able only to borrow 50%-75 percent of this face value.

Asset-based loans generally adhere to a strict set of guidelines regarding how collateral is treated of the physical assets used to obtain a loan. Above all else, the company usually cannot provide these assets as a type of collateral to any other lender. In certain cases there are instances where second loans on collateral may be illegal.

Prior to authorizing an asset-based loan, lenders can require an extremely lengthy due diligence procedure. This may comprise the examination of tax, accounting, and legal issues along with the examination of financial statements as well as asset appraisals. Overall, the underwriting on the loan will influence the approval of the loan as well as the rates of interest and allowable principal offered.

Receivables lending is an illustration of an asset-based loan that many companies may make use of. In receivables lending, companies takes out a loan against its accounts receivables to fill a gap between revenue booking and the receipt of funds. Receivables-based loans are generally a type of asset-based loan since the receivables are usually secured by collateral.

Businesses may want to retain control over their assets rather than selling them for capital; as a result, they are prepared to pay a fee for interest to obtain loans on these properties.

Key Differentialities

There are fundamental differences between these kinds of lending. Financial institutions more interested in cash flow loans are focused on the future prospects of their clients, whereas those who issue assets-based loans take a historical view by prioritizing the current balance sheet over future income statements.

Cash flow-based loans do not require collateral. assets-based lending is the foundation for having assets to post in order to limit risk. This is why companies might have a difficult time trying to get cash flow-based loans since they need to make sure that the working capital is allocated specifically for the loan. Certain companies won’t have the sufficient margin capacity to accomplish this.

The last thing to note is that each type of loan uses different metrics to determine if it is qualified. For example, cash flows loans are more interested in EBITDA that strip away the impact of accounting on income and focus more on net cash available. On the other hand assets-based loans are less concerned with income. However, institutions still be able to monitor liquidity and solvency, but have less requirements regarding operations.

Asset-Based Lending vs. Cash Flow Based-Lending

Asset-Based Lending

Based on the historical activities of how a business has made money in the past

Make use of assets as collateral

May be easier to obtain since there are typically fewer operating covenants

Tracked using liquidity and solvency but are not as focused on future operations

Cash Flow-Based Lending

Based on the prospective of the future of a company earning money

Make use of future operating cash flow as collateral

Might be more difficult satisfy operating requirements

Utilizing profitability metrics to remove the non-cash accounting impact

Subwriting and Business Loan Options

Businesses have a much wider selection of borrowing options than individuals. In the growing business of online finance, new types of loans and loan options are being developed to offer new capital access products for all kinds of businesses.

In general, the underwriting process for any type of loan will depend heavily on the borrower’s credit score as well as credit quality. Although a borrower’s credit score is often a key aspect in lending approval, each lender in the market is able to set its own underwriting guidelines to determine the credit quality of borrowers.

Comprehensively Unsecured loans of any type can be difficult to get and usually have higher interest rates relative to the risks of default. Secured loans backed by any type of collateral can decrease the chance of default by the underwriter and thus, potentially result in better loan terms for the borrower. Cash flow-based and asset-based loans are two types of secured loans businesses can look into when seeking to identify the best available loan conditions to reduce credit costs.

Are Asset-Based Lending better than Cash Lending based on Flow?

The one type of finance isn’t necessarily better than the other. One is better suited for larger companies that can post collateral or have very low margins. Another option may be better suitable for businesses that don’t own assets (i.e. large service firms) but are confident in the future cash flow.

Why do lenders look at the Cash Flow?

Lenders look at future cash flows because it is among the most reliable indicators of liquidity and being able to repay a loan. The projections for future cash flow are also an indicator of risk. companies that have greater cash flow are essentially less risky because they anticipating are able to meet liabilities as they become due.

What are the types of Asset-Based Loans?

Companies often pledge or use various types of collateral. This can include pending accounts receivables, unsold inventory manufacturing equipment, other long-term assets. Each of these groups will be classified with different amounts of risk (i.e. receivables may be uncollectable, land assets may depreciate in value).

The Bottom Line

In order to raise capital, businesses often have many choices. Two of these options are cash flow or asset-based financing. Companies with stronger balance sheets and higher existing assets may prefer securing assets-based financing. In contrast, companies with higher potential and less collateral might be better suited for funding based on cash flows.

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