Asset Financing
A type of borrowing related to the assets of a company
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What is Asset Financing?
Asset financing is a type of borrowing related to the assets of a company. In asset financing, the company uses its existing inventory, accounts receivable, or short-term investments to secure short-term financing.
There are two ways to finance assets:
The first involves companies using financing to secure the use of assets, including equipment, machinery, property, and other capital assets. A company will be entitled to full use of the asset over a set period of time and will make regular payments to the lender for the use of the asset.
The second variation of asset financing is used when a company looks to secure a loan by pledging the assets they own as collateral. With a traditional loan, funding is given out based on the creditworthiness of a company and the prospects of its business and projects.
Loans given out through asset financing are determined by the value of the assets themselves. It can be an effective alternative when a company is not qualified to secure traditional financing.
Summary
- Asset financing is used in two ways: to secure the use of assets and to secure funding from a loan.
- Both provide financial flexibility for a company by increasing short-term funding and working capital.
- More companies can qualify for asset financing compared to traditional financing since the assets are used as collateral.
Why Use Asset Financing?
1. Securing the use of assets
The capital expenditures for purchasing assets outright can put a strain on a company’s working capital and cash flow. Using asset financing provides a company with the assets they need to operate and grow while maintaining financial flexibility to allocate funds elsewhere.
Purchasing assets outright can be expensive, risky, and hold a company back from expansion. Asset financing provides a viable option to acquire the assets the business needs without excessive expenditures.
With asset financing, both the lenders (banks and financial institutions) and the borrowers (businesses) benefit from the structure. Asset financing is safer for lenders than lending a traditional loan.
A traditional loan requires the lending of a large sum of funds that a bank hopes they will get back. When the bank lends assets out, they know they will be able to at least recover the value of the asset’s worth. In addition, if borrowers fail to make payments, the assets can be seized by the lender.
2. Securing a loan through assets
Asset financing also involves a business looking to secure a loan by using the assets from their balance sheet pledged as collateral. Companies will use asset financing in place of traditional financing because the lending is determined by the value of the assets rather than the creditworthiness of a company.
If the company were to default on their loans, their assets would be seized. Assets pledged against such loans can include PP&E, inventory, accounts receivable, and short-term investments.
Early-stage and smaller companies often run into an issue with lenders because they lack the credit rating or track record to secure a traditional loan. Through asset financing, they can receive a loan based on the assets they need to secure financing for their day-to-day operations and growth.
It is commonly used for short-term funding needs to increase short-term cash and working capital. The funds will be put towards a number of items, such as employee wages, payments to suppliers, and other short-term needs.
The loans are typically easier and faster to obtain, which makes them attractive to all companies. With fewer covenants and restraints, they are more flexible to use. The loans are usually accompanied by a fixed interest rate, which helps the company with managing its budgets and cash flow.
Five Types of Asset Financing
1. Hire Purchase
In hire purchase, the lender purchases the asset on behalf of the borrower. The borrower will make payments to the lender to pay off the asset over time. At such time, the asset is owned by the lender until the loan is paid off. Once the final payment is made, the borrower will be given the option to purchase the asset at a nominal rate.
2. Equipment Lease
Equipment leases are popular options for asset financing because of the freedom and flexibility it comes with. For an equipment lease, the business (borrower) will enter a contractual agreement with a lender to use the equipment for its business for an agreed-upon period of time.
Payments are made by the business until the contractual period ends. Once the lease is up, the business can either return the rented equipment, extend its lease, upgrade to the latest equipment, or buy the equipment outright.
3. Operating Lease
An operating lease is similar to an equipment lease, except equipment leases are usually for short terms, and operating leases are typically longer but not for the full life of an asset. As a result, operating leases are often a cheaper option since the asset is being borrowed for a shorter amount of time.
Payments are only reflected for the time the asset is used and not for the asset’s full value. Operating leases are beneficial to businesses looking for short to medium-term use of equipment to fulfill their needs.
4. Finance Lease
The defining feature of the finance lease is that all rights and obligations of ownership are taken on by the borrower for the duration of the lease. The borrower holds responsibility for the maintenance of the asset during the life of the lease.
5. Asset Refinance
Asset refinance is used when a business wants to secure a loan by pledging the assets they currently own as collateral. Assets, including property, vehicles, equipment, and even accounts receivables, are used to qualify for borrowing. Rather than a bank judging the business on its creditworthiness, the bank will value the pledged assets and create a loan size based on the value of the assets.
Key Takeaways
The two types of asset financing provide flexible options for businesses and their use of assets. When asset financing is used to obtain the use of assets from a lender, a company’s cash flow and working capital are less strained.
The other variation of asset financing is used when a company wants to secure a loan with their assets pledged as collateral. The loans are typically easier to get due to the loan being granted based on the value of the assets rather than the creditworthiness of the company.
Additional Resources
CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:
