Nearly every small business will need borrower additional capital at some stage in its development. Even the most profitable companies eventually require access to external financing to gain the additional liquidity they need to expand business print and grow their operations.
The modern-day business climate is unpredictable, making demand forecasting and expense shortfall predictions more of a challenge than ever. That’s why most smaller companies demand fast access to capital that lets them cover their bills, acquire new suppliers, upgrade their equipment, and introduce new goods and services.
When businesses start searching for external financing options, whether from a bank or non-bank financial institution (NBFI), they invariably encounter two categories of financial instruments. The first type of product is described as an asset-based loan, while the second option is called a cash-flow loan. In the sections below, we’ll outline some key differences between the two loan types before weighing their pros and cons.
What are asset-based loans?
As implied in their name, asset-based loans are qualified and determined by the asset levels displayed on your current balance sheet. When small business owners opt for asset business loans to fill expense shortfalls, they can put up various company assets as collateral. A few common asset types include:
- Accounts receivable
- Equipment and machinery
- Business inventory
- Real property
Asset-based loans cater to small to medium-sized businesses that need fast access to short-term working capital. Larger, enterprise-level organizations use asset-based loans from time to time, but this is considerably less frequent.
What are cash flow loans?
Cash flow loans are established based on a business’s historical profits and forecasted sales revenue. Unlike asset-based loans, cash-flow loans don’t require assets as collateral for loans, and lenders qualify the loans based on a business’s documented cash flow data.
The cash flow loan types are the preferred (and usually the only) option for small businesses that generate predictable profits but lack the assets required to secure asset-based loans.
How do cash flow and asset-based loans differ?
Each loan type has its advantages and disadvantages. A company can benefit from one more than the other, depending on its circumstances. In some cases, companies can gain from leveraging some combination of the two types of financing.
Now, let’s explore a few key factors that can help businesses determine which financing option is the best solution for their organization.
Your collateral circumstances
As we briefly touched on above, if you have no collateral your company’s value is tied directly to its ability to produce future revenue. In this case, you’ll need to opt for a cash flow loan to cover a financial shortfall. Since nothing secures the loan, the borrower’s ability to repay must be evidenced by a personal credit rating.
Businesses that hold assets, on the other hand, could be in a better position to secure short-term financing because they can use those assets as collateral. Lenders tend to feel more confident writing secured loans because the lender can use the assets to recover losses should the borrower default.
Your eligibility and credit profile
We’ve discussed some of the pros and cons of each loan, but you’ll still need a positive personal and business credit rating to qualify for either type of financing. Your company’s credit rating is crucial to how much your business can borrow and whether or not it qualifies at all.
Cash flow loans are usually reserved for companies and business owners with superior credit ratings and a documented positive cash flow. Borrowers who evidence irregular or limited cash flow and have less-than-perfect credit ratings will find themselves better suited to an asset-based loan if they possess assets. Keep in mind that the value of your assets must be adequate enough to cover the bank’s or investor’s interest in creating the loan.
The purpose of the loan
Unlike other consumer loan types, the purpose and objectives of a cash flow or asset-based loan can vary significantly. Lenders will often use specific criteria to establish creditworthiness for cash flow-based financing called EBITDA, or earnings before interest, taxes, depreciation, and amortization. This metric helps assess risks that could emerge during an economic downturn or other complications, such as industry-specific shortages.
Wondering which loan is right for your business?
Now that we’ve covered a few pros and cons of asset-based lending vs cash flow lending, you might still have some lingering questions concerning which product is right for your company. Ultimately, it comes down to your credit rating, the assets you hold, and the needs and characteristics of your particular business.
New Bridge Merchant Capital provides working capital solutions to businesses of all types with a range of credit profiles, from good to poor. To learn more about your asset-based and cash flow lending options, connect with one of our senior working capital finance specialists now.
