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Overview

Cash flow-based lending

Asset-Based Lending

Key Differentialities

Business Loan Underwriting

Financial Lending FAQs

The Bottom Line

Corporate Finance Corporate Finance Basics

Cash Flow vs. business lending based on assets What’s the Difference?

By James Garrett Baldwin

Updated October 08, 2022

Review by Amy Drury

Cash Flow vs. Asset-Based Business Lending A Comprehensive Overview

If a business is a startup or a 200-year-old conglomerate like E. I. du Pont de Nemours and Company (DD) that relies on capital borrowed to run in the same way as cars run on gasoline. Business organizations have choices over individuals when it comes to borrowing which can make business borrowing a bit more complicated than the standard personal borrowing options.

Companies may choose to borrow money from banks or another institution to finance their operations, purchase another company, or engage in a major acquisition. In order to accomplish these goals, it can look to a multitude of options and lenders. In general the business loans as well as personal loans can be structured as either secured or unsecured. Financial institutions are able to provide a variety of lending provisions in the two categories, to meet the needs of every borrower. Secured loans are not secured by collateral, whereas secured loans are.

In the secured loan category, companies may consider asset-based or cash flow loans as an alternative. We will examine the differences and definitions of the two along with certain scenarios that show which is preferred over the other.

Important Takeaways

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

Cash flow-based loans focus on a company’s capital flows in the underwriting of the loan terms while asset-based loans consider balance sheet assets.

Cash flow loans could be a better option for businesses that do not have assets, such as service companies or for companies with greater margins.

Asset-based loans are typically better for firms with solid balance sheets who may have lower margins or unpredictability in cash flow.

Asset-based and cash flow-based loans are good choices for businesses seeking to efficiently control credit costs as they’re both secured loans that typically come with more favorable credit terms.

Cash Lending

Cash flow-based lending allows businesses to take out loans in accordance with the anticipated the future flow of cash for their business. With cash flow lending the financial institution offers a loan which is secured by the beneficiary’s past and projected cash flows. According to the definition, this means the company is borrowing funds from revenues that they anticipate they will receive in the future. The credit rating is also employed for this type 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 then pay back the loan and any interest on the profits and revenues generated by the employees on the future date. The loans do not require any kind of physical collateral such as assets or property, but a portion or all cash flows utilized during the underwriting process are typically secured.

To underwrite cash flow loans The lenders evaluate the expected future earnings of the company, its credit rating, and its enterprise value. The benefit of this approach is that the company could get financing more quickly since an appraisal of collateral is not required. Institutions typically underwrite cash flow-based loans by using EBITDA (a company’s earnings before tax, interest, depreciation, and amortization) along with the credit multiplier.

This method of financing allows banks to be aware of any risk caused by economic and sectoral cycles. When the economy is in a slump the majority of companies will notice a decline in their EBITDA, while the risk multiplier employed by the bank will also fall. The combination of these two decreasing numbers could reduce the available credit capacity for an organization , or even increase interest rates if provisions are included to be dependent upon these parameters.

In the case of cash flow loans are better suited to firms that have high margins, or have insufficient tangible assets to provide as collateral. Businesses that can meet these criteria include service companies or marketing firms as well as producers of low-cost products. The interest rates on these loans generally are higher than other loans due to the lack of physical collateral that could be accessed from the lending institution in event in default.

Both cash flow-based and asset-based loans are usually secured with the promise of assets collateral or cash flow for the lender.

Asset-Based Lending

Asset-based loans allow companies to take out loans according to the liquidation value of the assets they have on their balance sheets. A person who is receiving this form of funding by providing inventory, accounts receivable or other balance sheet assets as collateral. Although cash flow (particularly ones that are tied to physical asset) are considered when making this loan, they are secondary as a determining factor.

Common assets that are provided to secure an asset-based loan comprise physical assets such as real property, land as well as company inventory machines, equipment or vehicles, as well as physical items. Receivables are also included as a type of asset-based loan. If the borrower is unable to repay the loan or defaults, the lending bank has a lien on the collateral and may be granted approval to levy and sell the collateral in order to recuperate defaulted loan values.

Asset-based lending is a better fit for businesses with substantial balance sheets and lower EBITDA margins. This is also beneficial for businesses that need capital to operate and grow, particularly in industries that may not offer substantial cash flow. An asset-based loan can provide a company the capital needed to tackle its slow growth.

Like all 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 influence how much loan rate they are eligible for. Generally, good 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 only be able to get 50% to 75% of this face value.

Asset-based loans often maintain a very strict set of regulations concerning how collateral is treated of the physical assets utilized to get a loan. Most importantly, the company usually cannot offer these assets as a type of collateral to lenders. In certain cases the second loans on collateral may be illegal.

Before authorizing an asset-based loan the lender may need to go through a relatively lengthy due diligence process. This could comprise the examination of tax, accounting, and legal matters, in addition to the analysis of financial statements and asset appraisals. The underwriting process on the loan will influence its approval as well as the rates of interest and allowable principal offered.

Receivables lending is a prime example of an asset-based loan that many businesses could employ. In receivables lending, a company borrows funds against their receivables accounts to bridge a gap between revenue bookkeeping and the receipt of funds. Receivables-based lending is typically a type of asset-based loan because receivables are usually secured by collateral.

Some companies prefer to keep ownership over their assets, as opposed to selling them for capital; because of this, businesses are prepared to pay an interest expense to obtain loans on these properties.

Key Differences

There are ultimately several primary differences between these kinds of lending. Financial institutions more interested in cash flow lending focus on the future prospects of a business, while those who issue assets-based loans take a historical view by prioritizing the current balance sheet over the future income statements.

Cash flow-based loans do not require collateral. asset-based lending is rooting is the fact that you have assets to put up to minimize risk. For this reason, companies may find it harder to obtain cash flow-based loans because they have to ensure that working capital is allocated to the loan. Certain businesses simply don’t have sufficient margin capacity to accomplish this.

The last thing to note is that each type of loan employs different criteria to determine if it is qualified. Cash flows loans are more focused on EBITDA that eliminate the accounting impact on income and concentrate on the net cash available. On the other hand assets-based loans are less concerned with income. Institutions will continue to keep track of liquidity and solvency however they have less restrictions on operations.

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

Asset-Based Lending

Based on the past activities of how a business has been able to make money previously

Make use of assets as collateral

It is possible to get it since there are typically fewer operating covenants

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

Cash Flow-Based Lending

Based on the future prospective of a company earning money

Make use of future operating cash flow to serve as collateral

It may be more difficult to meet operating criteria

Tracked using profitability metrics that remove the non-cash accounting impact

Subwriting and Business Loan Options

Businesses have a much wider variety of borrowing options than individuals. With the increasing popularity of online finance, new types of loans and loan options are also being developed to offer new capital access options to all kinds of companies.

In general, the process of underwriting any kind of loan will depend heavily on the borrower’s credit score and credit quality. Although a borrower’s credit score is often a key aspect in lending approval, each market lender has their own set of underwriting standards to assess the credit quality of borrowers.

Completely Unsecured loans of any kind can be difficult to get and will usually come with greater interest rates relative to the amount due to the risks of default. Secured loans backed by any type of collateral may decrease the chance of default by the underwriter and therefore potentially lead to more favorable loan terms for the customer. Cash flow-based and asset-based loans are two kinds of secured loans a business can consider when seeking to identify the most favorable loan terms for reducing credit costs.

Is Asset-Based Lending more beneficial than Cash Lending that is based on flow?

A particular type of financing isn’t necessarily superior to the other. One may be better suited to larger companies that can post collateral or operate with very tight margins. The other option is suitable for businesses that don’t have assets (i.e. large service firms) however are confident about the future cash flow.

Why do lenders look at Cash Flow?

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

What Are the Types of Asset-Based Loans?

Companies may often pledge or use various types of collateral. This could include accounts receivables that are pending, unsold inventory manufacturing equipment, other long-term assets. Each of these categories will be classified according to different levels of risk (i.e. receivables might not be collectable while land assets can decrease to a lesser extent).

The Bottom Line

When trying to obtain capital, companies typically have many options. Two of these options are asset-based financing or cash flow-based financing. Companies with stronger balance sheets and higher existing assets may prefer securing assets-based financing. Alternatively, companies with greater potential and less collateral might be better suited for cash flow-based financing.