Asset-based lending versus cash flow lending

Asset-based lending

Asset-based lending (“ABL”) and cash flow-based lending are two different types of financing options available to businesses. While both types of lending can provide businesses with the capital they need to grow and expand, the.

Asset-based lending is a type of financing in which a lender uses the borrower’s tangible assets — such as inventory, accounts receivable (“A/R”), equipment, or real estate — as collateral for the loan. The loan amount is typically a percentage of the value of the assets. For example, a manufacturing company that has large inventories, A/R, property, equipment may use asset-based lending to finance their enormous cash flow needs. Most banks and commercial lenders in America are asset-based lenders.

In addition to commercial banks, equipment finance and leasing companies also provide asset-based lending to businesses that need to purchase equipment or machinery. Leasing typically costs more than senior lending as cash flow requirements are not as stringent.

One of the main advantages of ABL is that it allows business owners access to much-needed capital without having to give up equity. ABL banks look at primary, secondary, and tertiary considerations when evaluating an asset-based loan. In general, the three main considerations are:

  1. Cash flow – Bankers want to see that the business can generate free cash flow (“FCF”) – available cash flow from operations minus capital expenditures (“cap ex”). Free cash flow is the cash available to make debt payments (called “debt service”) or pay dividends. Even if a loan is fully collateralized, banker will want to see a FCF / debt service ratio (“DCR”) of at least 1.1 to make a loan. Banks never want to liquidate collateral to pay back a loan, as the cost to the bank are enormous. Bankers avoid these situations, called work outs, are to be avoided. And the best way to avoid a work out is conservative underwriting before a loan is issued.
  2. Collateral — The main factor that asset-based lenders consider is the value and quality of the assets that are being used as collateral. This may include inventory, accounts receivable, real estate, equipment, or other assets (“hard assets”). Intangible assets, while they may have some value to the business, are not considered as collateral in the eyes of most bankers. Examples of intangible assets include intellectual property, brand, goodwill, customer relationships, software, trade secrets, and licenses.
  3. Personal guarantee and creditworthiness — Lenders will also look at the borrower’s creditworthiness and ability to repay the loan. This may include evaluating the borrower’s credit score, personal financial statements, tax returns, and other financial information. Banks will want to see the net worth of their prospective borrower(s) to confirm the borrower(s) have enough personal net worth that, if needed, affords them the opportunity to have the borrower inject more cash into the business as opposed to forcing asset liquidations that may disrupt business operations and, consequently, further jeopardize the bank’s ability to repaid on its loan. Bankers call a borrower who has adequate liquidity, income, and adequate liquid net worth a “strong guarantee.”


Cash flow-based lending

With cash flow lending, a lender uses the borrower’s cash flow primarily in underwriting the loan. Hard tangible assets are typically not sufficient to collateralize the loan. Because cash flow lending is riskier than ABL, most banks do not make cash flow loans. For example, a software development business generating a significant amount of revenue but has few hard assets may use cash flow-based lending to finance its operations.

The strength of the SBA’s 7(a) loan program is it allows lenders to make cash flow loans, which is critical to support small businesses as few qualify for significant ABL financing due to a lack of adequate collateral. The SBA’s loan guarantee in essence provides SBA banks with the collateral the bankers needed to underwrite the loan. SBA loans will still require all business and personal collateral for 20%+ owners to be pledged for the loan, but the loan does not have to be 100% collateralized as is the case typically with an ABL loan.

Because SBA loans have higher interest rates than ABL loans due to risk, most banks run borrowers through a traditional lending program first. Borrowers who are declined an ABL loan, usually due to inadequate collateral, are frequently alerted to the possibilities of an SBA loan if the business has significant cash flow and a strong personal guarantee. Most SBA 7(a) loans are variable-rate loans priced at 2.75% – 4.75% above the prime interest rate (see current SBA loan rates here).

There are several types of lenders that provide cash flow-based lending. Factoring companies, for example, provide this type of financing to businesses that have a lot of accounts receivable but may not have a lot of cash on hand. Typically, an A/R factor lend 70% – 85% of the A/R of a business. Invoices not paid within 90 or 120 days are charged back to the borrower, thereby reducing the factor’s credit risk.

Additionally, some alternative lending platforms, such as online lenders, provide cash flow-based lending to businesses that may not qualify for traditional bank loans. Typically, online lenders provide smaller loans under $100,000, and those loans are primarily for working capital.


Home equity loan or personal loan

Lastly, some borrowers will opt to take a personal loan, home equity loan, or home mortgage to finance their businesses. To take out a home equity loan, entrepreneurs need significant home equity – the value of the home less the debt attached to it, a good credit score of mid-600s or higher, and stable income – W-2 income is preferred over 1099 income. Keep in mind that while a home equity loan or a home equity line of credit (“HELOC”) may be lower cost than an SBA loan, the entrepreneur’s home is at risk in case they fail to repay the loan. It’s important to consider the long-term financial stability of the business before making this decision, and we encourage entrepreneurs to discuss this financing option carefully with family members since a loan default impacts all those living in the home.

Asset-based lending and cash flow-based lending are two different types of financing options available to businesses. While both types of lending can provide businesses with the capital they need to grow and expand, they are based on different principles and are often used by different types of lenders. Asset-based lending is often used by businesses that have a lot of assets but may not have a strong cash flow, while cash flow-based lending is often used by businesses that have a strong cash flow but may not have a lot of assets.