n the There was a time when debt financing was considered a measure of the last resort for businesses, but now, it is one of the most preferred and cost-effective methods of sourcing funds. Organisations use various types of debt financing to fill the gap between their requirement of funds and the availability thereof, one of which is asset financing or asset-based finance.
In this article, we shall discuss what is asset-based finance, how it works, its types, and how it differs from a traditional loan.
What is meant by asset-based financing
Asset-based financing is a type of debt financing in which an organisation utilises its balance sheet assets to secure debt. The assets that are usually used to access debt through this route are accounts receivables, inventory, and short-term investments. An organisation usually resorts to asset-based financing to finance working capital gaps or other short-term shortages of funds. In exchange for the debt, the organisation pledges its assets to the lender. In asset finance management, the value of the pledged asset(s) is considered when approving a loan.
Types of asset-based financing
There are two major types of asset-based financing, which we discuss below:
1. Accessing credit by using balance sheet assets:
The first type of asset-based financing entails the use of balance sheet assets to access debt. Such debt is issued on the basis of the value of the assets being used as collateral rather than the creditworthiness of the borrowing entity as a whole. Therefore, this type of asset-based financing can be used even by organisations without a robust creditworthiness or credit history (including start-ups).
2. Securing the use of assets without outright purchase:
Another type of asset-based financing entails securing the usage of an asset without having to purchase it. Under this type of arrangement, a business can make periodic payments and use an asset that is owned by a lender or a third party. This way, the funds required for the purchase of a capital asset can be routed to other areas of operations. There are four major sub-types of this form of asset-based finance, namely:
- Hire purchase agreement: In this type of asset-based financing, the borrower makes periodical payments to the lender in exchange for the utilisation of an asset purchased by the latter. After the completion of the final instalments, the borrower has the option to purchase said asset.
- Equipment lease: This type of asset-based financing enables an organisation to use an asset for a predetermined time period in exchange for lease payments. After the completion of said period, the lease contract can be renewed, or the asset can be purchased or returned.
- Operating lease: In asset finance management, an operating lease is a contract granting the borrower usage rights of an asset for a short period. Since such leases are for short periods, the lease payments are determined based on said time period rather than the entire life of the concerned asset.
- Finance lease: Under this type of asset-based finance, the ownership of a leased asset and its maintenance responsibilities are held by the borrower for the duration of the lease.
Types of loans available under asset-based financing
Should a business choose to use its balance sheet assets to secure debt, it can have access to two major types of loans. These loans are secured loans and unsecured loans. Let us briefly discuss each type of loan available under asset-based financing.
- Secured loans
In this type of loan, a company pledges its balance sheet assets to access debt. The lender is entitled to secure ownership of the pledged assets in case of failure to repay the loan.
- Unsecured loans
This type of asset-based loan does not grant the lender any specific claims on the borrower's assets. In the event of the borrower becoming insolvent, the lender shall be repaid after the debts of the former's secured creditors have been settled.
How is asset-based finance different from a traditional loan
Although asset-based financing is a type of debt financing, it is different from a conventional loan. Under asset financing, the value of the loan is determined on the basis of the value of the assets being pledged. In stark contrast, traditional loans are granted depending on the overall creditworthiness and financial strength of an entity.
Therefore, even companies that are relatively new (for instance, start-ups) or do not have a positive credit history can access funds through asset-based financing by pledging valuable assets from their balance sheet. Since such assets are collateral for the debt, they are liable to be seized should there be a default in the repayment of the loan.
Another key difference between asset financing and traditional loans is that the former type of debt financing can be secured relatively quickly. Furthermore, asset-based finance is generally used to fulfil the short-term requirements for funds — for instance, payment of salaries, purchase of important raw materials, etc. Traditional loans, on the other hand, are used for short-term and long-term shortfall of funds alike.
Is asset financing different from asset-based lending?
Asset-based finance and asset-based lending are similar concepts. In both types of debt financing, there is an asset that serves as collateral to the loan. Let us understand this with the help of an example. Let us say you wish to purchase a house and finance it (partly or wholly) with a home loan.
If you secure the loan, the house shall be considered collateral to the loan, and the ownership shall be transferred to you only after the complete repayment of the loan. Failure to repay the loan could result in the house being seized by the lender. Similarly, an organisation's balance sheets used as collateral in asset-based finance can be seized by the lender in the event of default on repayment.
The bottom line
Asset-based finance is an important source of debt finance for businesses. This type of finance is accessible to large corporations and small companies that may not necessarily have substantial creditworthiness.
