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Cash flow-based lending

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Cash Flow in comparison to. 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. Business Lending based on Assets A Review

If a business is a new venture or an established conglomerate like E. I. du Pont de Nemours and Company (DD), it relies on capital borrowed to run in the same way as cars run on gasoline. Business entities have many more options than individuals when it comes to borrowing which can make 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, acquire another business, or take part in a major acquisition. For these purposes, they may be possible to look at a variety of options and lenders. In a broad generalization, business loans, like personal loans can be structured as either secured or unsecured. Financial institutions can offer a wide range of loan options within the two categories, to meet the needs of each individual borrower. The unsecured loans are not backed by collateral, whereas secured loans are.

In the secured loan category, businesses may consider asset-based or cash flow loans as a potential alternative. Here we will look at the definitions and differences between them, and some scenarios on when one is preferred over the other.

The most important takeaways

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

Cash flow-based loans take into account a company’s cash flows in the underwriting of the loan conditions, while asset-based loans look at assets in the balance sheet.

Cash flow-based loans are a good option for firms that don’t have assets such as service companies or those with larger margins.

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

Cash flow-based as well as asset-based loans can be a good option for businesses looking to efficiently control credit costs as they are typically secured loans which usually come with higher credit terms.

Cash Flow Lending

Cash flow-based lending permits businesses to take out loans based on the projected the future flow of cash for the company. In the case of cash flow lending, a financial institution grants the loan that is secured by the recipient’s past and projected cash flows. According to the definition, this means the company is borrowing funds from revenues that they anticipate receiving in the future. Credit ratings are also used in this kind of lending to serve as an important factor to consider.

For instance, a business trying to pay its payroll obligations might use cash flow finance to pay its employees now and then pay back the loan as well as any interest accrued on the earnings and profits generated by employees on the future date. The loans do not require any kind of physical collateral such as assets or property, however, some or all cash flows that are used for underwriting are typically secured.

In order to underwrite cash flow loans the lenders look at projected future profits of the company and its credit rating and the value of its business. The advantage of this strategy is that the company could be able to obtain financing faster since appraisement of collateral is not needed. The majority of institutions underwrite cash flow loans using EBITDA (a company’s earnings before tax, interest, depreciation and amortization) in conjunction with an increase in credit.

This type of financing allows banks to be aware of any risk caused by economic and sectoral cycles. When the economy is in a slump there are many businesses that will experience decreases in their EBITDA and the risk multiplier used by banks will decline. This combination of declines can affect the credit available to an organization or increase rates of interest if provisions are made to be based on these criteria.

In the case of cash flow loans are more appropriate for firms that have high margins or lack sufficient hard assets to offer as collateral. Businesses that can meet these criteria include service firms as well as marketing companies and producers of low-cost products. The interest rates on these loans generally are more expensive than alternatives because there is no physical collateral that could be accessed by the lender in the case in default.

Both cash flow based and asset-based loans are typically secured by the pledge of assets collateral or cash flow in the loan bank.

Asset-Based Lending

Asset-based lending allows businesses to borrow money by calculating the liquidation cost of the assets they have on their balance sheet. A recipient receives this form of financing by offering inventory, accounts receivable or other assets on the balance sheet as collateral. Although cash flow (particularly those tied to any physical assets) are considered when providing this loan, they are secondary as a factor determining the loan.

Common assets used to secure an asset-based loan comprise physical assets such as real property, land, company inventory machines, equipment vehicles, and physical products. Receivables can also be included as a form of asset-based lending. In general, if a borrower fails to repay the loan or defaults, the lending institution has a lien on the collateral and may be granted approval to levy and sell the assets in order to recoup defaulted loan values.

Asset-based lending is a better fit for organizations that have large balance sheets, and have less EBITDA margins. This can also be good for companies that require funds to expand and operate in particular industries which may not have a substantial cash flow. A capital-based loan could provide a business with the necessary capital to overcome its lack of rapid growth.

Like all secured loans, loan to value is an important factor in the case of asset-based lending. The creditworthiness of a company and its credit rating will help to affect how much loan rate they are eligible for. Generally, good credit quality firms can borrow from 75 percent to 90 percent of the face value of their collateral assets. Businesses with less credit quality may only be able to get 50 to 75% of this face value.

Asset-based loans often maintain a very strict set of regulations about how collateral is treated of physical assets that are used to obtain a loan. In addition, the company usually cannot provide these assets as a form of collateral to other lenders. In some cases the second loans on collateral can be illegal.

Before approving an asset-based loan, lenders can require an extensive due diligence process. This could include the inspection of tax, accounting and legal matters, in addition to the review of financial statements and appraisals. The underwriting process of the loan will determine the approval of the loan as well as the rates of interest charged and allowable principal offered.

Receivables lending is a prime instance of an asset-based loan that many businesses could utilize. In receivables-based lending, a business is able to borrow funds against their accounts receivables to fill a gap between revenue recording and receipt of funds. Receivables-based lending is typically a type of asset-based loan since the receivables are generally secured with collateral.

Businesses may want to retain ownership over their assets as opposed to selling them for capital; because of this, businesses are prepared to charge interest charges to take loans against these assets.

Key Differentialities

There are fundamental differences between these forms of lending. Financial institutions more interested in cash flow loans are focused on the long-term prospects of a business, while institutions that issue assets-based loans take a historical view by prioritizing the balance sheet over future income statements.

Cash flow-based loans don’t use collateral; the basis of asset-based lending is having assets to post in order to limit risk. For this reason, companies may find it harder to get cash flow-based loans since they need to make sure that working capital is appropriated specifically to the loan. Certain businesses simply don’t have enough margin to make this happen.

The last thing to note is that each type of loan utilizes different metrics to judge eligibility. The cash flow-based loans are more concerned with EBITDA which eliminates the accounting impact on income and concentrate on the net cash available. On the other hand, asset-based loans are less concerned with income; institutions will still keep track of liquidity and solvency but have less requirements regarding operations.

Asset-Based Lending vs. Cash Flow Based Lending

Asset-Based Lending

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

Make use of assets as collateral

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

Tracked using liquidity and solvency but not so focussed on the future operation

Cash Flow-Based Lending

Based on the potential future of a company earning money

Use future operating cash flow to serve as collateral

May be more difficult to satisfy operating requirements

Utilizing profitability metrics to strip away non-cash accounting impacts

Subwriting and Business Loan Options

Businesses have a wider range of options for borrowing than private individuals. In the ever-growing field of online financing and loans, new kinds of loans and loan options are also being developed to offer new capital access options for all kinds of businesses.

In general, the process of underwriting any kind of loan will be heavily dependent on the credit score of the borrower and credit quality. While a borrower’s score is typically a primary factor in determining the loan’s approval, every lender on the market has its own set of underwriting criteria for determining the credit quality of the borrowers.

Completely, unsecured loans of any kind could be difficult to get and usually have higher relative interest rates due to the risk of default. Secured loans backed by any type of collateral could decrease the chance of default for the underwriter and consequently, could result in more favorable loan conditions for the lender. Cash flow-based and asset-based loans are two potential types of secured loans a business can consider when determining the most advantageous loan conditions to reduce the costs of credit.

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

One type of financing isn’t necessarily better than the other. One is better suited for larger businesses that are able to provide collateral or operate with extremely tight margins. Another option may be better to be used by companies that do not own assets (i.e. large service firms) but are confident in future cash flow.

Why do lenders look at the flow of cash?

The lenders look at the future cash flow because that is one of the greatest indicators of liquidity as well as being capable of repaying a loan. Forecasts of future cash flows are also an indicator of risk. businesses with a higher cash flow are less risky because they anticipating have more resources available to meet liabilities as they are due.

What are the different types of Asset-Based Loans?

Businesses may frequently pledge or use various types of assets as collateral. This includes pending accounts receivables and inventory that is not sold, manufacturing equipment, or other assets that are long-term. These categories will be defined various amounts of risk (i.e. receivables might not be collectable, land assets may depreciate by value).

The Bottom Line

If you are trying to get capital, companies typically have several choices. Two of these options are cash flow or asset-based financing. Businesses with better balance sheets and higher assets in place may be more inclined to secure assets-based financing. In contrast, companies with higher prospects and less collateral may be more suited to the cash-flow-based finance.

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