09 Jul Asset-based lending vs. cash flow based lending
The vast majority of SMEs use some form of debt finance to fund their growth, and this form of finance can be offered as either asset-based lending or cash flow based lending. Both are excellent sources of funding, and can easily be used alongside each other too. Here we discuss the differences between them, the main types of finance in each category, and give you some lesser-known fintech options too.
Asset-based lending is a great way to release working capital tied up in your assets. Companies can release the cash value held within their existing assets, like stock, machinery and property to raise funding. Raising finance from the value of customer invoices is also asset-based lending (ABL).
So how does asset-based lending work? Businesses borrow a pre-agreed amount of money based on the liquidation value of specific assets on their balance sheet. It predominantly focuses on a business’s current assets, i.e. accounts receivables and inventory but can include fixed assets too.
Invoice finance is the most common forms of asset-based finance. It’s concerned with current assets, i.e. a company’s receivables. The two main forms of invoice finance are:
Invoice Factoring – where a factor will advance a percentage of the value of outstanding invoices to your business. The factor takes control of your ledger, chasing and processing payments. Your customers will, therefore, know that you are using finance.
Invoice Discounting – is essentially the same, however, you retain control and responsibility over your ledger and collection of payments.
Because eligibility is weighed primarily against assets, the cash flow of a business is usually a secondary consideration. This means that asset-based lending applicants generally don’t need as high a credit rating.
How Credit is Provided
The amount of credit provided in asset-based lending relies upon three main elements:
- The Borrowing Base – the value of eligible assets that are available as collateral
- The Advance Rate – the maximum percentage of the collateral value that the finance company will lend
- The Headroom – the difference between the maximum advance and the actual amount drawn
The percentage varies depending on the type of asset used as security. The advance can vary from 70-80 percent of eligible receivables to 50 percent of finished inventory value. The amount of credit available also changes in line with the perceived value of your assets, for example, if their value depreciates.
Asset-based lending usually takes the form of a term loan, a leasing agreement, or a revolving line of credit.
Limitations of Asset-Based Lending
Due to the nature of asset-based lending, there are several limitations that can make it a less than perfect solution for many businesses.
The setup processes can cause missed opportunities
Registering fixed assets as collateral can prove a lengthy process before any funds are released. These delays can cause a business to be at risk of missing out on good business opportunities.
There can be high levels of monitoring and disclosure
The value of physical assets changes regularly. Therefore asset-based lenders that loan cash against fixed assets often require frequent and detailed reporting on top of the usual financial reporting associated with other types of finance.
Low credit value from certain assets
If you’re looking to borrow against fixed-assets, the credit available can be less than 50% of the perceived value of inventory or equipment. This is due to the fact that these types of assets are often sold quickly through liquidation or auction in order for the lender to get its money back.
Assets must be clear of any liabilities
In order for your business to secure asset-based lending, you must address any accounting, tax, or legal issues prior to the agreement. This is because they could affect the lender’s ability to secure and sell your assets in liquidation should you default.
The level of credit can reduce unexpectedly
Because the level of available credit relies almost entirely on the perceived value of the assets in question (including customer invoices), the level of funding available goes down if your liquidity contracts. This means the borrowing base can suddenly shrink due to an unforeseen event, such as the insolvency of a major customer.
Conversely, if your collateral value goes up, your loan limits generally won’t go up with it. Your assets could therefore become collateralised lower than their actual value.
When is asset-based lending the right choice?
Businesses tend to use asset-based lending because of the easier qualification criteria and credit guidelines. There is a market for this type of lending, thanks to the tightening of traditional bank lending criteria. However, not all businesses are rich in either current assets or fixed assets. A retailer, for instance, is not going to have any customer invoices to borrow against. You should always talk with your business advisor about what kind of finance is right for you.
“ABL facilities are not designed to invest in long-term capital projects.” - Grant Thornton
Cash flow based lending
With asset-based lending, how much a company can borrow is determined by its collateral base, but with cash flow based lending, it’s determined by the amount of cash it can generate.
Cash flow-based lending allows your business to borrow based on its projected future cash flows, and in particular, its revenue and profit margins. Your collateral is therefore not the primary consideration. In order to get a cash flow based loan, your company must prove to the lender that you have and will have sufficient cash available after expenses to repay the credit.
The amount that a lender will advance you is determined by your perceived capacity to repay the loan. This is based on EBITDA (earnings before interest, taxes, depreciation, and amortization) in conjunction with a credit multiplier. The lender will analyse your credit score and management information (MI) to decide upon your creditworthiness, and your repayment schedule will usually be based upon the timing of your cash flow.
The pros and cons of different types of cash flow based lending
Cash flow based lending has evolved. The range of cash flow finance options has expanded from traditional term loans and business credit cards to innovative and flexible credit products such as Pay4’s revolving facility, which is specifically designed to support the growth of successful, profitable businesses.
Business Credit Cards
Business credit cards are issued based on your business’s financial performance, credit rating and size. The most important metrics that lenders consider include are your firm’s revenue (often requiring a minimum amount of annual sales) and its business credit score. Business credit cards are relatively easy to secure if your business is well established, however they often require personal guarantees, and include high interest-rates, late fees and annual charges.
Term loans are a common form of cash flow based lending. They can be useful for large, long-term projects or capital expenditure. However, they do have limitations. Firstly, they have a specified end date. This means you have a specific date by which the entire loan must be repaid. You can’t redraw on the loan until it’s fully paid off. This makes it relatively inflexible as a method of financing growth and ties up chunks of your future profits.
Also, with a term loan, normally have to pay interest on the original amount you borrowed throughout, instead of only on the balance outstanding – which can prove to be costly over the long term.
Structured Revolving Credit
A revolving credit facility is a pre-approved credit limit that you can draw down against, repay and redraw as many times as needed up to your approved limit. You only pay interest on the outstanding balance, or a simple transaction fee each time it is used. This can make it cost-effective compared to a term loan.
A revolving line of credit is open-ended and does not have a set end date. Once approved, you can borrow as much as you like up to your limit without having to reapply every time. This makes it far more flexible and less time-consuming than fixed-term business loans.
On top of this flexibility, Pay4’s product has an additional benefit not often found with other revolving credit facilities. With Pay4 there are no non-utilisation fees either. So you can dip in and out to suit your cash flow situation.
When is cash flow based lending the right choice?
Cash flow finance products look at the bigger picture when assessing risk and deciding how much you can borrow. Lenders seek to understand your future business potential. They assess the strength of your business cash flow statements, both current and projected, rather than just the tangible assets on your balance sheet. This ensures that the loan size, terms and repayment are all based upon your business’s actual cash generation. Risk of default due to diversion of funds is therefore usually reduced.
Asset-based lending arrangements such as invoice finance can be unsuitable for particular kinds of business. For example, retailers who don’t invoice their customer base cannot use invoices as collateral. There may also be restrictions on receivables generated from foreign sales. Cash flow finance can, therefore, be a far more suitable option in these situations.
Cash flow based lending is generally better suited if your business maintains relatively high margins on its balance sheets, or lacks hard assets to offer as collateral. This can be particularly useful for businesses such as service companies, marketing firms and manufacturers of low-margin products. However, thanks to the complementary nature of innovative finance products such as Pay4 and other forms of finance such as ‘stretch loans’, businesses are now able to create a balanced finance package that utilises both their assets and their cash flow status.
Securing cash flow finance
To maximise your chances of securing cash flow based finance, you need to make sure you have the necessary information in order. This includes:
- A healthy credit score
- Past cash flow statements with a record of regular cash flow income
- Profit and loss statements
- A budget and forecast including cash flow projections
- A realistic and flexible business plan
- Smart invoicing and debt collection strategies
Choosing and securing the right form of debt finance requires a thorough assessment of your business and the types of finance available. Talk to your business advisor or accountant about what business finance may be right for you. Pay4 is designed to work alongside other forms of finance, including asset-based and cash flow based products, enabling your business to implement a funding strategy that primes it for success.