In order to sustain and scale its operations, every business needs to rely on borrowed capital at some point in time. Short-term financing is a key requirement for small businesses which can help them handle financial downturns and register growth in the long term.
There are two types of lending styles that can be chosen depending upon the needs of the business i.e. cash flow loans and asset-based loans. In the simplest words, cash flow loans are granted against the estimated future cash flows of a company. On the contrary, asset-based lending follows the collateral route and lets businesses borrow capital against the different assets on their balance sheet.
There are some key differences between the two types of lending styles that typically any NBFC and bank will look into, before deciding on which loan suits the lender’s business best. Let’s learn more about them here.
Key Differences between Cash Flow and Asset Based Lending
Before diving into the core differences between the two, here is a quick look at what each type of loans entail and its meanings:
What is Cash Flow Lending?
Cash flow-based loans take into account the overall financial health of the borrower’s business and grant loans on the basis of future cash flows, basically the profits and revenue margins of the business.
After a study of the past cash flows and a projection of the future cash flows, the lender will figure out the payment capacity of the borrower. It simply means that the borrower anticipates future revenues which will be used to repay the loan.
There is no asset or collateral backing the loan, which also renders the borrower’s creditworthiness an important criterion to be considered. For example, a company looking to service customer payments can utilise cash flow finance to meet the necessary obligations and repay the loan from the profits generated from the same business at a future date.
What is Asset Based Lending?
Asset-based lending primarily takes into account the liquidation value of a company’s assets on its balance sheet and grants loans accordingly. Some of the most common assets that can be used as collateral against such loans include real estate, property, machinery & equipment, company inventory, accounts receivable, etc.
Asset-based loans are best suited for companies that have a strong balance sheet and need finance to fund their growth, especially businesses that do not want to restrict their borrowing criteria as future revenues or profits.
Key Differences Between Cash Flow Lending and Asset-based Lending:
Following are some of the key differences between the two types of lending:
1. Focus:
A major difference between cash flow and asset-based lending lies in the lender’s focus on insuring them. Typically, cash flow based loans will focus on the business’s future projected cash flows, whereas asset-based loans will primarily focus on the assets in the balance sheet of the business.
2. Collateral:
Cash flow-based loans have no concept of collateral and completely depend on the company’s ability to generate future income. The borrower’s credit rating plays an active part in deciding whether to grant cash flow based loans.
On the contrary, asset-based loans look at the current assets of the company and what can be taken as collateral. Such collateral assets can be utilised by the lender in future, in the event of a loan default on the part of the borrower. The lender has the right to possess a lien on the assets and use the sale proceeds of the same, in case the borrower is unable to meet the payment obligations.
3. Suitability:
Since every business is different from the other, the loan terms need to be tailored to fit the different criteria and needs. For example, a business that has its working capital tied up in assets majorly and cannot produce enough evidence to support future cash flows, will not be granted a cash-based loan. Similarly, companies that enjoy huge margins but do not have enough hard assets to offer as collateral are best suited for cash flow based loans. A few examples of the same could be marketing firms or even service-based companies.
4. Criterion:
Since the focus of both types of loans is considerably different from the other, the criterion used to grant loans is quite different too. For example, EBITDA is a common criterion while granting cash flow based loans. EBITDA (earnings before interest, taxes, depreciation and amortisation) along with a credit multiplier is a common factor calculated by lenders. This method is a good way to loop in any risks that may arise by way of economic downturns or industry-specific shortfalls.
Typically cash flow based loans are easy to acquire as there is no collateral required to back the loans. This is most suitable for SMEs and MSMEs, and in the wake of the pandemic, banks and NBFCs can look to focus on cash flow-based lending to gain more customers. However, it is also critical to invest in a robust automated system to safeguard the lender from potential defaults or NPAs.
Finezza offers best in class lending and credit evaluation services for businesses of all sizes and ambitions. Our industry-leading loan origination system (LOS) and loan management system (LMS) have helped countless lending businesses automate their processes and scale their business.
Get in touch with us to know more about how we can help your business.
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