Should you apply for an asset based loan or a cash flow based loan for your business?

Both types of loans can provide business owners with the funding they need but which one is better for you depends on the type of company you run.

What are cash flow based loans and asset based loans and what are their advantages and disadvantages?

What is asset based lending?

An asset based loan is a loan based and secured on the value of your:

• accounts receivables (accounts receivables are your company's outstanding invoices on goods or services you have already delivered) or

• the equity in any land or buildings your company owns.

A lender may advance you up to 90% of the value of the accounts receivable line (as shown on your balance sheet) in the form of a revolving credit facility.

The actual amount you're able to borrow will also depend on how creditworthy your lender assesses your typical clients to be. The amount you can borrow will also likely increase if your turnover increases.

Alternatively, you may choose to offer as security:

• company inventory (materials, merchandise, goods, and other items your business could sell to make a profit) or

• balance sheet assets (physical assets like vehicles and fixed assets like equipment and machinery).

If you offer your inventory or assets as security, the value placed on them by the lender may just be their value at auction rather than their actual market value. This means that you might not be able to borrow as much as you might need.

Asset based lending is generally better for companies with lower profit margins and more substantial balance sheets.

This is because companies with lower profit margins often find it harder to generate the cash they need for general trading and for growth. And, as the loans are secured, the interest rates on an asset based loan are generally lower.

What is cash flow lending?

Cash flow based lending is better for companies with higher profit margins or for those which lack hard assets as collateral which they can offer to lenders as security.

Cash flow loans are popular with service companies, marketing firms, manufacturing companies with low margins, and retailers among others.

On a cash flow loan application, a lender will examine:

• credit ratings (your personal credit rating and your company's credit rating),

• your company's "enterprise value" (the market value of your business),

• your company's anticipated future cash flows (in other words, how much money you're likely to be paid by your clients from the sales you make over a given length of time), and

• frequency of deposits (when you'll actually be paid - sometimes called "consistency of cash flow")

In order to determine how much they'll actually lend you, a lender first consider your company's EBITDA margin (earnings before interest, taxes, depreciation, and amortisation - this is a way of measuring your profitability).

They'll then apply a credit multiplier to that margin. Credit multipliers are different for each industry and they're designed to measure the risks associated with lending to companies in different sectors.

This financing method enables lenders to maximise the amount of funding they can advance to you while factoring in the likelihood of any future downturns companies like yours might face.

You do not have to offer any collateral to your lender as security to borrow money with cash flow lending. However, this does mean that the interest rate you pay is higher than on asset based loans.

If you're thinking that cash flow lending does sound very similar to invoice finance, you're right but only to a point.

With invoice finance, you can only borrow against invoices you've issued on completed orders however, with cash flow based business loans, you're actually borrowing against expected future revenues and invoices.