What is Asset Finance?
Asset finance lets a company use its existing assets like inventory or accounts receivable as collateral to secure short-term loan financing. The use of a company’s balance sheet assets, such as short-term investments, inventories, and accounts receivable, to borrow money or obtain a loan is referred to as asset financing. The corporation borrowing the cash is required to provide the lender with a security interest in the assets.
Businesses generally employ asset finance to borrow against assets that they already possess. Accounts receivable, inventory, machinery, and even buildings and warehouses can be used to secure a loan. These loans are generally utilized for short-term financial needs. For example, to pay employee wages or to acquire raw materials needed to manufacture the items supplied. As a result, rather than acquiring a new asset, the firm is utilizing its existing assets to compensate for a working cash flow shortage. However, if the corporation defaults, the lender can still seize assets and sell them to repay the loan amount.
What is an asset?
An asset is a valuable item or resource that helps a company achieve its goals, grow, or produce revenue. This might be anything from an office chair to a large commercial truck. There are two main categories of assets:
- Hard assets – are tangible, high-value objects like business vehicles, trucks, and tractors. The category also includes machinery such as engineering and manufacturing equipment, and even buildings and office space.
- Soft assets – are less tangible, less durable assets such as IT hardware, software packages, catering equipment, office furniture, and security systems. This category may have limited resale value at the conclusion of the finance arrangement.
Asset Finance – A Closer Look
Asset finance varies from typical financing in that the borrowing offers part of its assets in exchange for a rapid cash loan. A typical financing arrangement, such as a project-based loan, would typically include procedures like business planning and projections, among other things. When a business borrower needs a short-term cash loan or operating capital, asset financing is frequently employed. The borrowing business often promises its accounts receivable when employing asset finance. Also, the utilization of inventory assets in the borrowing process is not unusual.
Asset Finance – Securing the use of new assets
Capital outlays for the outright acquisition of assets can impose a strain on the company’s working capital and cash flow. Asset financing allows a firm to acquire the assets it requires to function and develop. At the same time, retaining the financial flexibility to transfer needed cash elsewhere. Buying assets directly may be too costly and limit a company’s ability to grow. Asset finance is a suitable solution for acquiring the assets that a firm needs without incurring exorbitant outlays of cash.
The structure of asset financing benefits both the lenders (banks and financial institutions) and the borrowers (companies). Lenders prefer asset finance to regular lending because it is less risky. A conventional loan necessitates the lending of a big quantity of money, which the bank expects to recoup. However, when a bank lends against an asset, they know they will be able to recoup at least the asset’s value. For example, if borrowers fail to make payments, the lender may confiscate their assets.
Asset Finance – Securing a loan with existing assets as collateral
Asset financing also includes a company seeking to secure a loan by pledging assets from its balance sheet as collateral. Companies will employ asset finance instead of traditional financing since the funding is based on the value of the assets rather than the company’s creditworthiness. If the corporation fails to repay its loans, its assets will be taken. Property, inventories, accounts receivable, and short-term investments are examples of assets that can be pledged against such loans.
Start-ups and smaller businesses sometimes have difficulties with lenders. This is because they lack the credit rating or track record required to receive a typical loan. However, they can obtain a loan based on asset financing. New assets they require for operations and expansion can be more readily acquired. It is widely utilized to enhance short-term liquidity and working capital for short-term financial needs. The cash can be used for a variety of purposes, including employee paychecks, supplier payments, and other short-term requirements. Loans are often easier and faster to secure, making them appealing to all businesses. They are more adaptable to use since they have fewer covenants and constraints. The loans are often accompanied by a set interest rate, which aids the organization in budgeting and cash flow management.
Asset Financing vs Asset-Based Lending
Fundamentally, asset finance and asset-based lending are phrases that essentially mean the same thing. For example, when an individual borrows money to buy a house or a car through asset-based lending, the property or vehicle acts as collateral for the loan. If the loan is not repaid within the stated time period, it goes into default, and the lender may take and sell the automobile or property to pay off the payment. The same logic applies to firms purchasing assets.
Asset Finance – Secured and Unsecured Loans
Asset finance was once seen to be a last-resort method of financing. However, the stigma associated with this source of raising capital has faded over time. This is especially true for small businesses, startups, and other organizations that do not have the track record or credit rating to qualify for other funding sources. There are two sorts of loans that are given.
- A secured loan – is when a firm borrows and pledges an asset as collateral for the debt. Instead of looking at the overall creditworthiness of the firm, the lender assesses the value of the asset pledged. If the loan is not repaid, the lender may confiscate the asset provided as security for the debt.
- Unsecured loans – do not specifically entail collateral. But, if repayment is not completed, the lender may have a broad claim on the company’s assets. Secured creditors often receive a higher share of their claims if the firm goes bankrupt. As a result, secured loans often have lower interest rates. This makes them more appealing to businesses seeking asset finance.
Asset Finance – Pros & Cons
Asset financing is frequently utilized as a short-term financial option. For example to pay staff, suppliers, or to support expansion during a temporary cash shortfall. When compared to typical bank loans, it offers a more flexible method of financing. It provides an easy option to enhance working capital for expanding enterprises and start-ups in particular.
Advantages of asset finance:
- Convenient – Easier to obtain than traditional bank loans
- Manageable – Fixed payments make budgeting and cash flow simple to manage
- Affordable – Most agreements have fixed interest rates
- Clear downside – Failure to pay only results in the loss of assets
Disadvantages of asset-based finance:
- Loss of collateral – There is the risk of losing important assets required for running a business if payment is not made
- Low appraisals – The value of the assets which a loan is secured against can vary, with the possibility of low valuations
- Short term – Not as effective for securing long term funding
Asset finance can help many businesses, but it’s important to be sure this financing method is right for your business model.
Here’s an example of asset financing. Consider a manufacturing business that has to purchase additional machinery due to increased demand. The equipment needs to move quickly to address the additional demand. However, it would cost thousands of dollars to purchase outright, which the company cannot afford. So, the company decides to go with the hire purchase option after conducting proper research. Another advantage is that the company does not have to provide security because the asset itself serves as loan collateral.
The company and the lender agree that the lender will purchase the machinery and the company will lease it back from them for 48 months. As a result, the company obtains the asset to immediately boost the company’s production capacity within a few days after the loan is finalized. At the end of the contract, the company will pay a small fee to own the equipment outright.
Up Next: What Is a Crummey Trust?
A Crummey trust is an estate planning tool that takes advantage of the gift tax exclusion while limiting the recipient’s access to the funds. It allows you to give money or assets to another person while keeping the flexibility to place limits on when the recipient can access the money.
A Crummey trust is named after Clifford Crummey, the originator of this form of trust. It is intended to provide financial transfers to beneficiaries while reducing gift tax. This sort of trust is commonly used by parents who desire to make financial contributions to minor or adult children. However, it can be established by anybody on behalf of a beneficiary. For example, Crummey trusts can be used as an alternative to custodial accounts. This spares the requirement that an adult manages assets until the beneficiary reaches the age of majority. A custodial account automatically provides children ownership of assets after they reach legal age. However, a Crummey trust can provide more flexibility and control over when beneficiaries can access assets.