Overview
Cash flow-based lending
Asset-Based Lending
Key Differences
Business Loan Underwriting
Financial Lending FAQs
The Bottom Line

Corporate Finance and Corporate Finance Basics

Cash Flow and. business lending based on assets: What's the Difference?
By James Garrett Baldwin
Updated October 08, 2022.
Review by Amy Drury
Cash Flow and. Asset-Based Business Lending: An Overview

If a business is a startup or a 200-year-old conglomerate like E. I. du Pont de Nemours and Company (DD) is dependent on borrowed capital to operate in the same way as an automobile runs on gasoline. Business organizations have different options when it comes to borrowing, which makes the process of borrowing for business a little more complicated than personal borrowing choices.

The business may want to borrow money from banks or another institution to finance their operations, buy an additional company, or participate in a major purchase. To do these things it may be possible to look at a variety of options and lenders. In general terms that is, business loans as well as personal loans are classified as either secured or unsecured. Financial institutions can provide a variety of lending options in both of these broad classifications that can be tailored to each individual borrower. The unsecured loans are not backed by collateral, whereas secured loans are.

In the secured loan category, companies may consider asset-based or cash flow loans as an alternative. Here we will look at the differences and definitions of the two along with certain scenarios that show which is preferred over the other.
Important Takeaways

Both cash flow-based and asset-based loans are typically secured.
Cash flow-based loans focus on a company's capital flows when determining the loan terms , while asset-based loans look at assets in the balance sheet.
Cash flow-based loans could be a better option for firms that don't have assets like many service businesses or for entities that have higher margins.
Asset-based loans are typically better for businesses with strong balance sheets , but who might operate with tighter margins or unstable cash flow.
Asset-based and cash flow-based loans can be good options for companies looking to effectively control credit costs as they're both secured loans which typically have higher credit terms.

Cash Credit

Cash flow-based loans allow businesses to borrow money in accordance with the anticipated future cash flows of a business. With cash flow lending a financial institution grants the loan that is secured by the recipient's past and future cash flows. By definition, this means the business borrows funds from revenues that they anticipate they will receive in the near future. The credit rating is also used in this form of lending to serve as an important criterion.

For instance, a firm trying to pay its payroll obligations might use cash flow finance to pay its employees now and repay the loan and any interest on the revenues and profits generated by the employees on an undetermined date. These loans are not backed by any form of collateral physical like assets or property but a portion or all of the cash flows utilized in the underwriting process are generally secured.

In order to underwrite cash flow loans the lenders look at expected future company incomes as well as its credit score and the value of its business. The advantage of this strategy is that a company can get financing more quickly because an appraisal of collateral is not required. Institutions usually underwrite cash flow-based loans using EBITDA (a business's earnings prior to interest, taxes, depreciation, and amortization) in conjunction with a credit multiplier.

This type of financing allows the lenders to take into account any risk caused through economic cycles and sectors. During an economic downturn there are many businesses that will experience a decline in their EBITDA as well as the risk multiplier employed by the bank will also decrease. Combining these two declines can affect the amount of credit available for an organization or increase rates of interest if provisions are made to be based on these factors.

Cash flow loans are more appropriate for firms that have high margins or do not have enough physical assets to use as collateral. Businesses that can meet these criteria include service firms as well as marketing companies and manufacturers of low-cost products. The interest rates on these loans generally are higher than the alternative because there is no physical collateral that can be secured through the loan provider in the case in default.

Both cash flow-based and asset-based loans are typically secured by the promise of assets or cash flow collateral to the lending bank.
Asset-Based Lending

Asset-based lending allows companies to take out loans by calculating the liquidation cost of assets on their balance sheet. The recipient is provided with this type of funding by offering inventory, accounts receivable or other balance sheet assets as collateral. While cash flows (particularly ones that are tied to physical assets) are considered when making the loan but they are not considered in determining the amount.

Common assets used to secure an asset-based loan are physical assets such as real estate, land, properties such as inventory of companies machines, equipment vehicles, and physical items. Receivables can also be included as an loan based on assets. In general, if the borrower fails to pay back the loan or defaults, the lending institution holds a lien on the collateral, and is able to obtain approval to levy and sell the collateral to recoup defaulted loan values.

Asset-based loans are better suited for businesses with substantial balance sheets, and have less EBITDA margins. It is also a good option for businesses that need capital to run and expand especially in sectors that might not provide substantial cash flow. A capital-based loan could provide a business with the needed capital to address the issue of slow growth.

Like other secured loans, loan to value is a factor when it comes to asset-based lending. The creditworthiness of a company and its credit rating can affect how much loan rate they are eligible for. Generally, good credit quality companies can borrow anywhere from 75 percent to 90% of the face worth of collateral asset. Businesses with less credit quality might only be able to get 50 to 75% of this face value.

Asset-based loans typically adhere to a strict set of regulations regarding how collateral is treated of the physical assets used to obtain a loan. In addition it is not possible for a company to offer these assets as a type of collateral to lenders. In certain cases, second loans on collateral may be illegal.

Before approving an asset-based loan lenders may require an extensive due diligence procedure. This process can comprise the examination of accounting, tax, and legal issues along with the analysis of financial statements and appraisals. The underwriting process on the loan will influence its approval as well as the rates of interest charged and allowable principal .

Receivables lending is a prime illustration of an asset-based loan that many businesses could utilize. In receivables lending, companies borrows funds against their accounts receivables to fill a gap between revenue recording and receipt of funds. Receivables-based loans are generally a type of asset-based loan as receivables generally secured with collateral.

Businesses may want to retain control over their assets as opposed to selling them to raise capital. as a result, they will charge interest charges to borrow money on these properties.
Key Differences

There are ultimately several primary distinctions between these types of lending. Financial institutions that are more interested in cash flow lending focus on the future prospects of a company, whereas institutions issuing asset-based loans have a more historical perspective by prioritizing the current balance sheet over future income statements.

Cash flow-based loans do not require collateral. assets-based lending is the foundation for the fact that you have assets to put up in order to limit risk. This is why companies might have a difficult time trying to get cash flow-based loans since they need to make sure that working capital is allocated for the loan. Certain companies won't have the margin capabilities to do this.

The last thing to note is that each type of loan utilizes different metrics to assess qualification. The cash stream-based loans are more interested in EBITDA which eliminates the accounting impact on income and focus more on net cash available. Alternatively assets-based loans are less concerned with income. Institutions will continue to keep track of liquidity and solvency but they are not required to monitor operations.
Asset-Based Lending in contrast to. Cash Flow Based-Lending
Asset-Based Lending

Based on the past activities of how a business has been able to make money previously

Utilize assets as collateral

May be easier to obtain since there are typically fewer operating covenants

It is tracked using solvency and liquidity but are not as focussed on the future of operations

Cash Flow-Based Lending

Based on the prospective of the future of a company earning money

Utilize future operating cash flow as collateral

It may be more difficult to achieve operating requirements

Utilizing profitability metrics to remove the non-cash accounting impact

Business Loan Options and Underwriting

Businesses have a much wider selection of borrowing options than people. In the ever-growing field of online financing, new types of loans and loan options are also being developed to offer new capital access products to all kinds of companies.

In general, underwriting for any type of loan will depend heavily on the borrower's credit score and credit quality. While a borrower's credit score is often a key factor in lending approval, every lender in the market has their own set of underwriting guidelines to determine the credit quality of the borrowers.

In general Unsecured loans of any kind could be harder to obtain and typically come with higher relative interest rates due to the possibility of default. Secured loans backed by any type of collateral can lower the risk of default by the underwriter and thus, potentially result in better loan terms for the lender. Cash flow-based and asset-based loans are two possible types of secured loans that a company can think about when determining the most advantageous loan terms to lower the costs of credit.
Is Asset-Based Lending Better Than Cash Lending that is based on flow?

One type of financing isn't always better than the other. One is better suited for larger companies that can post collateral or have very tight margins. The other option is suited for companies that don't own assets (i.e. large service firms) but are confident in future cash flow.
Why do lenders look at the flow of cash?

Creditors are interested in future cash flow as it is one of the best indicators of liquidity as well as being able to repay the loan. Future cash flow projections are also an indicator for risk; companies that have greater cash flow are more secure because they anticipate that they will are able to pay off debts as they come due.
What are the different types of Asset-Based loans?

Businesses may frequently offer pledges or other types of assets as collateral. This could include accounts receivables that are pending as well as inventory that has not been sold, manufacturing equipment, or other assets that are long-term. These categories will be classified according to different amounts of risk (i.e. receivables could be uncollectable, land assets may depreciate by value).
The Bottom Line

In order to raise capital, businesses often have many options. Two such options are cash flow or asset-based financing. Companies with strong balance sheets and larger assets in place may be more inclined to secure the asset-based financing. Alternatively, companies with greater potential and less collateral might be more suited to cash flow-based financing.
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