Asset Based Lending vs. Cash Flow Lending – What is the Difference?
There are two categories of loans available for personal or business loans: Cash flow loans and collateral loans (sometimes called asset based loans).
Cash Flow Loan
A cash flow lender bases their credit decision primarily on the strength of your company’s cash flow generation or your personal income. In the case of a business loan, the lender will scrutinize your company’s financial statements and focus on specific financial ratios, namely interest coverage and leverage ratios to determine whether the business can support the interest payments and eventual repayment of principal and will then test to see how much debt can be supported. Cash flow loans can either be secured (like a bank loan which is secured through a General Security Agreement over the entirety of the business or through a personal guarantee) or unsecured (like a credit card).
Unlike cash flow lending, asset based lending is more focused on the quality and value of specific assets than on the cash flow of the business or your personal income.
There are four categories of assets that a private lender will typically consider using as collateral for a loan:
These can include equipment or machinery, accounts receivable, inventory or even smaller items such as computers or photocopiers
These can include used cars, luxury automobiles, trucks, trailers
This includes houses, condominiums, commercial properties or cottages.
An asset based lender will value the specific asset that will be used as collateral and will base the loan off of this value. Because the lender has tangible collateral, either by registering a lien against the asset or physically holding the asset in its possession, the lender may not need to do much due diligence on you as an individual or your business to assess whether you have the ability to repay the loan.
The key things asset based private lenders will look for during their diligence are:
Do you own the asset?
Do you have the right to pledge it as collateral?
Are there any other liens already on the asset?
What is the value of the asset if the lender had to sell it quickly?
In the event of a default, they have the right to liquidate the asset in order to recoup the amount owed to the lender (this is referred to as “realizing on the security”).
Because an asset based lender will base their loan on the value of the asset, and not on the cash flow potential of the business or your personal future salary or income potential, an asset based loan is much quicker to implement and typically has a lot less paperwork than a cash flow loan.
There are two important considerations before getting an asset based loan:
Your loan amount will be restricted to the value of the asset used as collateral. Unlike cash flow lending, where as long as your income can support an increase in the loan amount, with asset based lending unless you have more collateral, a lender will not be able to lend more. Sometimes this can actually work to your benefit. If your assets are growing faster than your income, an asset based loan is much better than a cash flow loan since the loan amount available to you will more quickly keep up with your growth.
In the event of default, a lender will attempt to recoup the amount owed to it by liquidating the asset. This may mean that if you miss interest payments and can’t agree to a restructuring plan with your asset based lender, you risk losing the asset that was used as collateral. If the asset is a valuable piece of equipment that is critical to your business, or a family heirloom diamond ring, be sure to consider how you would feel if you lost the asset and the impact a loss could have on your business. Of course, even a cash flow lender will try to recover their loan in the event of a default and may also try to take possession of your assets but it is much more clear cut with an asset based lender.