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Did you know that your company can receive funding by using its existing assets as security? This type of funding is referred to as asset finance, and it is actually very common especially among startups and growing businesses. Like with most things, asset financing has both benefits and downsides, and it is important to recognize what these are before you can decide whether or not to fund your business in this way.
There is a reason why a company’s assets are listed in a company’s balance sheet, and that is because they have intrinsic value. These assets can include anything of value such as:
For instance, consider a logistics company that transports customer goods in trucks across the country. This fleet of trucks is an asset for the company and can be used to secure a loan. The lender will only need to value the existing assets in order to determine the amount of loan to offer and at what terms. In this case, the fleet of trucks is used as a security to guarantee the loan to be issued, which is asset financing.
However, it is important to note that this is just one form of asset finance, but it should give you an idea of why many businesses use this kind of funding option.
The main reason why a business may need asset financing is to increase its cash flow. Imagine a company that needs to buy new equipment in order to increase their production. An obvious option is to go looking for the equipment and buying it outright, but this wouldn’t be a smart choice. After all, no one pays 5 years’ worth of rent upfront just because they have the money to do it, so why pay for equipment that way. Furthermore, if a company that could afford to buy the equipment decides to do so, this would have a negative impact on the cash flow. Perhaps the low cash flow will affect other expenses such as purchasing inventory, paying staff, rent, etc. That is why such big companies will almost always prefer to go for asset finance instead.
Another reason why companies opt for asset finance is to raise cash flow quickly. It is not uncommon for a company’s cash flow to dip due to one of many reasons, and the company may need to raise cash flow quickly. Maybe inventory needs to be replenished due to increased demand from customers or maybe some expenses cannot be met. In such situations, the asset finance process is easier and less costly than most other lending options.
Consider a company applying for a business loan to buy equipment, the process would take a long time before approval. For example, the average waiting time to get an SBA loan is between 60 and 90 days. This is because lenders must weigh numerous factors about your business before offering a loan. On the other hand, asset finance is a lot easier because actual assets are used as collateral. That way, the application becomes a lot easier and thus faster to process and approve.
An upcoming business is also more suited for asset finance because it will not be disqualified on the basis of its credit score. Because an asset is used as collateral for the loan, even a company that would otherwise not be approved for a loan can still be funded.
All of the examples provided in previous sections involve just one type of asset financing, yet there are different forms of the same concept.
This is one of the most common forms of asset finance, whereby assets such as vehicles, buildings, equipment, etc. are used as collateral to secure a loan from a lender. Most businesses use this type of asset financing when they need to quickly raise cash flow to make up employee wages or purchase inventory. It is also a popular option for debt consolidation for businesses.
Since the asset is used as collateral, its value will determine the loan amount that will be awarded by the lender. Typically, the lender will perform a valuation of the asset first and then propose a certain loan amount. Repayment terms for the amount are also agreed upon, and the lender may seize the asset if the terms are not kept.
Here, a company rents equipment to use for its business on a lease from a lender for a specified period. Payments are then made periodically as agreed by the lessor and lessee until the lease expires. When that happens, the lessee can either return the equipment, extend the lease, buy it outright or upgrade to a piece of better equipment under a new lease. Throughout the lease period, the equipment is still owned by the lessor, so it is not listed as an asset on the balance sheet. Instead, it is placed in the profit and loss account since payments are made periodically.
It is not difficult to see why many companies would prefer this kind of asset financing, particularly because it allows a lot of freedom. Take the case of the aforementioned logistics company having leased a few trucks for a year. At the end of the year, the company can decide, depending on its needs, whether to extend the lease or not. This is preferable to holding assets that were only necessary for a certain period. In fact, the Equipment Leasing Association of America reports that 80% of companies lease equipment rather than buying.
Also referred to as contract hire, this is very similar to equipment leasing for the lease period being shorter and responsibility for maintenance lies with the lessor. An operating lease, therefore, is best for a company that simply needs to fill a gap in, say, production, but only for a short period. With this kind of asset financing, the lessee is free from responsibility and they can also cancel the lease before the expiry date, although at a penalty.
Other than being a quick fix solution, operating leases are also cheaper because the lessee is not paying the full value of the asset. Similar to the equipment lease too, this lease will not be listed on the balance sheet as an asset but under the P/L account.
With hire purchase, the lender will purchase the item on behalf of the company seeking asset finance and then will be repaid over a longer period of time as installments. In the end, the item will be fully owned by the company, so this is listed as an asset. Plus, the insurance and maintenance costs incurred will all be paid by the company.
Companies choose to go the hire purchase route when they need to purchase critical assets to the business but would rather spread out payments. In so doing, the cash flow doesn’t take too much of a hit from the purchase while there is still a guarantee of ownership after payment is completed.
This is also called a capital lease, and it is what you get after combining hire purchase and equipment leasing. It is similar to a hire purchase plan because the asset is capitalized on the balance sheet both as an asset and liability. At the same time, it is similar to an equipment lease because rent is listed on the P/L account.
The reason why it isn’t the same as hire purchase is that the rent paid overtime is the same as the asset’s value. Add to that, insurance and maintenance costs are catered for by the lessee. However, the asset is still technically the property of the lessor, and the lessee has to return it to the lessor after the period passes, and this makes it more of a lease.
A company may choose such an arrangement mainly for tax benefits because it is only capitalized on the balance sheet. That means paid rent can be offset against the profit gained to claim VAT thereby making it more tax efficient.
When a company decides to seek asset financing, it should expect to experience both positive and negative consequences. From the above types of asset finance, there are clearly a lot of options to consider, and these are the effects you can expect to have afterward:
Many companies prefer asset finance because it is a faster way of raising cash flow compared to conventional financing methods. It takes time to get a bank’s approval for a business loan, much longer than customers, staff, and suppliers are willing to wait. For this reason, asset financing becomes a great alternative to keeping the business running smoothly.
Apart from the speed, asset finance is also issued at a lower interest rate because of the presence of collateral. Without collateral, the lender can only rely on the company’s credit score to set the terms of the loan. For a small or midsized company without an established credit record or one with a lower credit score, interest rates for a business loan could be brutal or just denied. Lower interest can save a company lots of money in the long term that could be used elsewhere.
Moreover, interest rates are fixed over the term of the loan compared to variable interest seen with typical bank loans. Inasmuch as variable interest can have some advantages, most companies would prefer predictability over potential and minimal cost savings. Under a fixed rate, the company knows exactly how much it will have to pay, and can, therefore, plan ahead.
Finally, there’s a comfort that comes to knowing what would happen in the worst-case scenario, and asset finance provides that. If your company is unable to keep up with the required payments, the lessor simply moves in and repossesses the asset in dispute. Although this isn’t a pleasant situation, at least nothing else in the company comes user question. But in the case of bank loans, for example, things can get very messy when both parties cannot agree on the way forward.
Unfortunately, the same reason why asset finance is so popular is also the same reason why it might be deadly. Give thought to a company that, in order to raise cash flow, sought asset refinancing and put up some crucial assets as security. If they were to be unfortunate enough not to make it out of the cash crunch, those assets would be seized by the lessor. If these assets were crucial to the company’s operations, then it would mean the business would just halt. That is when the company would realize that it may have shot itself in the foot.
Worse still, companies don’t always get the best value for their assets. Lenders will often undervalue certain assets, and since this is what determines the loan amount, offer only a little amount of financing. It is not uncommon for this to happen, and companies in desperate situations more often than not take the bad deal. It really is akin to kicking a man when he’s down.
In the end, there is only one question left to answer, and that is whether or not to put up some of your company’s assets to receive funding from a lender. Knowing both the risks and advantages, you should be able to weigh between the two making the best decision about the way forward. But if you need a simple guideline to help you, remember to look at the future of your company.
All the benefits to be had from asset finance exist in the future from the cost savings to the company’s ability to keep moving in case of a seizure of assets. Meanwhile, the downsides are very real in the short term and could lead to the demise of your company. That means you need to consider if the funding will really help your business survive years down the road or not. If so, then this could be the way to go and if not, perhaps look for other funding methods.
