Asset-based loans are the most frequent form of loans. The lender (a bank or other financial provider) loans money in an agreement that is secured by collateral. When the company seeking the loan cannot provide enough cash flow or cash assets to cover the debt, the lender may offer to approve the loan with its physical assets as collateral. For example, a new gym might be able to obtain a loan only by using its equipment as collateral. The financial providers usually prefer liquid assets. Accordingly, the securities offered by the borrower may affect the loan conditions.
For instance, a company is willing to borrow $ to expand the business. If the company pledges the highly liquid marketable securities on its balance payday loans in Tennessee sheet as collateral, the lender may grant a loan equaling 70% of the face value of the collaterals. If the firm’s securities value $100,000, the lender will be willing to loan $70,000. On the contrary, if the company chooses to pledge less liquid assets (e.g., real estate or equipment), it may only be offered 50% of its required loan.
Finally, if the borrower fails to pay back the loan, the lender has a lien on the collateral that can be used to oblige the debtor to sell the securities and recoup the defaulted loan value.
Cash flow loans
Cash flow loans (or cash flow financing) are a form of cash flow finance with which a company receives a loan guaranteed by the future (expected) cash flow. To underwrite this kind of loan, the bank takes into account two main indicators: cash flow history and future incomes. As far as the cash flows records are concerned, the lender will look through the CFS and OCF.
All cash flows are reported in the company’s Cash Flow Statement (CFS). The CFS records the company’s net income or profit for a specific period. In addition, the CFS shows investments in the company (e.g., equipment or security) and any financing activity, such as raising money through lending or issuing a bond. Another document that the lender will analyze during the assessment is the Operating Cash Flow (OCF). The OCF includes expenses from running the company, such as bills paid to suppliers and operating income generated from sales.
After having assessed the company’s history, the lender will need to estimate the future cash flows that will pay back the loan. Two factors are particularly relevant for this second analysis: the company’s receivables and payables. Account receivables are payments owed from customers for goods or services sold on credit. Usually, receivables are collected in terms ranging from 30 to 90 days. Therefore account receivables can be regarded as future cash flows and help estimate how much cash the business will generate in the future.
A lender must also consider the accounts payables-i.e., short-term debt obligations, such as money owed to suppliers. Payables are used to estimate the net amount of cash the business will generate to pay back the loan.
Cash Flow Loans vs. Asset-Based loans
As we have seen, the two instruments have different features that have to be considered to determine which loan can be more suitable for the company.
Asset-based loans are better suited for organizations that have large balance sheets and lower EBITDA margins. This instrument can be beneficial when a business is in need of liquidity for investment within an industry that does not provide relevant cash flow potential.
The company’s credit rating is the main indicator to determine the amount to loan. For instance, high credit quality companies can borrow from 75% to 90% of the face value of their collateral assets. On the contrary, enterprises with weaker credit ratings might only be able to obtain 50% to 75% of this face value.
Cash flow loans fit better companies operating in industries with high cash flow potential (e.g., service companies, marketing firms, and manufacturers of low-margin products) but do not have many physical assets to pledge. The procedure to access a cash flow loan is much easier than asset-based lending in terms of the length and accuracy of the pre-authorization assessment.
The lender uses a far narrower range of factors and a quicker process to determine qualifications to borrow, concentrating almost exclusively on cash flow instead of the business’s assets. Yet, given the lack of physical assets as collateral and the rapidity of the procedure, the interest rates for cash flow loans are higher than asset-based loans.
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