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Overview

Cash Lending based on Flow

Asset-Based Lending

Key Differences

Business Loan Underwriting

Financial Lending FAQs

The Bottom Line

Corporate Finance and Corporate Finance Basics

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

By James Garrett Baldwin

Updated October 08, 2022.

Reviewed by Amy Drury

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

It doesn’t matter if a business is start-up or a conglomerate with a history of 200 years like E. I. du Pont de Nemours and Company (DD) is dependent on borrowing capital to function like an automobile is powered by gasoline. Business entities have many choices over individuals in borrowing, which makes business borrowing a bit more complicated than personal borrowing options.

Companies may choose to borrow money from a bank or another institution to finance their operations, purchase an additional company, or participate in a major purchase. To do these things it may be possible to look at a variety of lenders and options. In a broad generalization that is, business loans, like personal loans can be classified as either secured or unsecured. Financial institutions offer a wide range of lending options within the two categories to accommodate the needs of each borrower. Unsecured loans are not backed by collateral while secured loans are.

Within the secured loan category, businesses may look at asset-based or cash flow loans as a potential option. In this article, we will discuss the definitions and distinctions between the two, as well as various scenarios to show when one is more preferred to the other.

The most important takeaways

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

Cash flow-based loans consider a company’s cash flows when determining the loan terms while asset-based loans consider balance sheet assets.

Cash flow loans may be better for businesses that do not have assets, such as many service companies or those with higher margins.

Asset-based loans are often better for firms with strong balance sheets that might operate with tighter margins or unstable cash flow.

Asset-based and cash flow-based loans can be good options for businesses looking to efficiently manage credit costs since they are typically secured loans which typically have better credit terms.

Cash Lending

Cash flow-based lending allows businesses to borrow money according to the forecasted future cash flows of the company. In cash flow lending, the financial institution offers the loan that is secured by the recipient’s past and future cash flows. According to the definition, this means the company is borrowing money from expected revenues they anticipate receiving in the future. Credit ratings are also employed in this kind of lending as a crucial factor to consider.

For instance, a firm which is trying to meet its payroll obligations might use cash flow finance to pay employees right now and repay the loan and any interest on the revenues and profits generated by employees on the future date. These loans don’t require any type of physical collateral like property or assets but some or all cash flows utilized during the underwriting process are usually secured.

In order to underwrite cash flow loans, lenders examine the expected future earnings of the company, its credit rating, and its enterprise value. The advantage of this method is that a company can be able to obtain financing faster, as the appraisal for collateral is not required. Institutions typically underwrite cash flow-based loans using EBITDA (a company’s profits before interest, taxes, depreciation, and amortization) along with the credit multiplier.

This method of financing allows the lenders to take into account any risk caused through economic cycles and sectors. During an economic downturn the majority of companies will notice a decline in their EBITDA and the risk multiplier employed by the bank will also decrease. Combining these two declining numbers can reduce the available credit capacity for 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 best suited for companies that maintain high margins, or have insufficient physical assets to use as collateral. Companies that meet these qualities include service firms or marketing firms as well as producers of low-cost products. Interest rates for these loans tend to be more expensive than alternatives due to the lack of physical collateral that can be accessed from the lending institution in case in default.

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

Asset-Based Lending

Asset-based lending allows companies to borrow money based on the liquidation value of assets on the balance sheet. The recipient is provided with this type of finance by offering accounts receivable, inventory or other balance sheet assets as collateral. Even though cash flows (particularly ones that are tied to physical assets) are taken into consideration when granting this loan, they are secondary in determining the amount.

Common assets that are provided to secure an asset-based loan are physical assets such as real estate, land, properties, company inventory equipment, machinery, vehicles, or physical products. Receivables may also be considered as an asset-based lending. Overall, if the borrower is unable to repay the loan or defaults, the lender has a lien on the collateral and may be granted approval to levy and sell the assets in order to recuperate the defaulted loan values.

Asset-based loans are better suited for companies with large balance sheets as well as smaller EBITDA margins. It is also a good option for companies that require capital to run and expand in particular industries that may not offer substantial cash flow. A asset-based loan can give a company the needed capital to address its slow growth.

As with the majority of secured loans, loan to value is a factor when it comes to asset-based lending. A company’s credit score and credit rating can affect the loan to value they can receive. Typically, high credit quality companies can borrow anywhere from 75% to 90 percent of the face worth of collateral asset. Firms with weaker credit quality might only be able to borrow 50 to 75% of the face value.

Asset-based loans typically adhere to a strict set of guidelines concerning how collateral is treated of physical assets that are used to obtain a loan. In addition, the company usually cannot offer the assets in the form of collateral to lenders. In some cases there are instances where second loans to collateral are illegal.

Before authorizing an asset-based loan lenders may require a relatively lengthy due diligence process. This could consist of a thorough examination of tax, accounting and legal issues along with the review of financial statements and asset appraisals. The underwriting process of the loan will determine the approval of the loan as well as the interest rates charged and the allowable principal amount offered.

Receivables lending is a prime illustration of an asset-based loan that many businesses could employ. In receivables-based lending, a business borrows funds against their receivables in order to bridge the gap between revenue bookkeeping and the cash receipt. Receivables-based lending is generally a type of asset-based loan as receivables generally pledged as collateral.

Some companies prefer to keep control over their assets, as opposed to selling them to raise capital. because of this, businesses are willing to pay an interest expense to borrow money from these investments.

Key differences

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

Cash flow-based loans don’t use collateral; assets-based lending is the foundation for the fact that you have assets to put up in order to limit risk. Because of this, businesses might have a difficult time trying to secure cash flow-based loans as they must ensure working capital is appropriated specifically for the loan. Some companies simply won’t have sufficient margin capacity to accomplish this.

The last thing to note is that each type of loan utilizes different metrics to determine if it is qualified. For example, cash flows loans are more focused on EBITDA that eliminate the accounting impact on income and focus more on net cash available. In contrast 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 in contrast to. Cash Flow-Based Lending

Asset-Based Lending

Based on the previous activities of how a business 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 are not as focussed on the future of operations

Cash Lending based on Flow

Based on the future prospective of a business that is earning money

Make use of future cash flow from operations as collateral

Might be more difficult achieve operating requirements

The metrics are used to track profitability and eliminate the impact of non-cash accounting on

Optional Business Loans and underwriting

Companies have a greater selection of borrowing options than individuals. In the growing business of online financing and loans, new kinds of loans and loan options are also being created to help provide new capital access options for all types of businesses.

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

In general, unsecured loans of any kind can be harder to obtain and will usually come with greater interest rates relative to the amount due to the possibility of default. Secured loans supported by any kind of collateral can decrease the chance of default by the underwriter and thus, potentially result in better loan conditions for the borrower. Cash flow-based and asset-based loans are two kinds of secured loans businesses can look into when seeking to identify the most advantageous loan terms for reducing the costs of credit.

Is Asset-Based Lending Better Than Cash Lending that is based on flow?

The one type of finance isn’t always better than the other. One type of financing is more suitable for larger companies that can post collateral or have very low margins. The other may be better suitable for businesses that don’t possess assets (i.e. many service companies) but are confident in the future cash flow.

Why are lenders looking at Cash Flow?

Creditors are interested in future cash flows because it is among the most reliable indicators of liquidity and being capable of repaying a loan. The projections for future cash flow can also be an indicator of risk. companies with higher cash flow are less risky since they anticipate they’ll have more resources available to meet liabilities as they become due.

What are the different types of Asset-Based loans?

Companies often make pledges or use different kinds of assets as collateral. This could include accounts receivables that are pending as well as inventory that has not been sold, manufacturing equipment, or other assets that are long-term. Each of these categories will be classified according to different amounts of risk (i.e. receivables could be uncollectable and land assets could decrease by value).

The Bottom Line

If you are trying to get capital, companies often have many choices. Two such options are cash flow or asset-based financing. Businesses with better balance sheets and larger assets in place may be more inclined to secure asset-based financing. Alternatively, companies with greater prospects and less collateral may be more suited to the cash-flow-based finance.

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