What is Asset Financing?

Two types of asset financing exist: the use of financing to acquire control over an asset and the securing of a loan via assets on the balance sheet. Making the right asset financing decision can have major implications for business, but small businesses, in particular, have a high degree of sensitivity to decisions that impact cash flow.

Business assets require invested capital, but these same assets can also convert into cash to cover working capital needs. Read on to learn more about the different asset finance options and how smart business owners make use of asset financing to spread out cash outflows as well as turn fixed assets into cash on the balance sheet. 

An Overview of Asset Financing

Businesses have a variety of assets on the books, including current assets such as inventory, accounts receivable, and short-term investments. Other types of assets include long-term assets and investments which lack immediate liquidity. 

These assets can serve many purposes, including helping a business to go about its daily operations and act as collateral for a business loan. For instance, a business may purchase or lease machinery in order to conduct daily production operations and a finance provider wants to secure the financing with additional collateral owned by the business. 

Small businesses in particular have a need to manage day-to-day cash flow and working capital. When purchasing expensive assets, these businesses might choose to take advantage of alternative financing arrangements that reduce the strain of such large purchases of hard assets on free cash flow. 

Types of Asset Financing Strategies

Businesses will typically make use of one of five basic types of asset financing strategies, including financial leases, operating leases, equipment leases, hire purchase, and asset refinancing.  

Financial Lease

Finance leases, also known as capital leases, confer all obligations and rights on the borrower of the asset. In exchange, the borrower will make payments to continue the arrangement. This contract acts much like any other rental contract, but the borrower will hold the asset on its books and receive full use of the asset. 

Operating Lease

An operating lease helps businesses take ownership over an asset on a short-term basis without outright purchasing the asset. The leasing firm will also take responsibility for the maintenance and upkeep of the asset. 

Equipment Lease

One of the more common asset financing arrangements, equipment leases, provide businesses with the ability to rent a piece of equipment in exchange for regular rental payments. The lessor buys the asset on behalf of the lessee and rents it out at a set rate. At the end of the lease term, the lessee may choose to extend the contract. 

Hire Purchase

Under a hire purchase arrangement, also known as a “never-never,” a business acquires control over an asset or piece of equipment by first paying a lump sum up-front and repaying the balance plus any interest owed over an agreed-upon period of time.

Asset Refinance

Businesses often have valuable assets sitting on their balance sheets. However, these assets often lack liquidity, especially in the case of fixed assets and those which cannot easily convert to cash within one year. For businesses that need cash but lack the means to quickly liquidate assets, an asset refinancing arrangement may help to generate that needed cash. Under this arrangement, a business mortgages an asset to a financing company in exchange for the cash value of the asset less any fees. 

Also see: What is invoice factoring?

Why Use Asset Financing?

Remember the first accounting equation any student learns: Assets = Liabilities + Owner’s Equity. In other words, a business’s assets come from a combination of debt and equity financing. However, the reverse of that statement, that equity comes from assets, can also form a means by which a business can continue to fund its operations when it lacks the cash balance needed to make immediate expenses.

Whether a business needs to control an asset without investing a substantial amount of cash on the balance sheet to acquire it or make use of its own assets in order to fund working capital requirements on a day-to-day basis, asset financing provides a range of options offering flexibility in meeting everyday financial commitments such as paying staff and purchasing inventory.  

How Asset Financing Affects Free Cash Flow

An asset finance company can help businesses manage short-term funding needs. Without free cash flow, a business cannot pay suppliers, employees, utilities, rent, and so forth. By gaining access to the cash value of assets, or forgoing the high outflow of cash associated with the purchase of expensive fixed assets, a business can better manage its working capital requirements.

How is Asset Financing Different from a Loan?

With traditional financing, a lender will enter into an agreement with a business that involves a lump sum cash payment in exchange for principal and interest repayments over a designated period of time. Additional factors such as default risk and interest rates come into play as well.

Unsecured loans do not require a business to pledge collateral, whereas a secured loan requires some form of guarantee. Asset financing, on the other hand, looks more like a leasing arrangement or mortgaging of assets. 

The advantages of asset finance compared to traditional lending options include the added flexibility that contracts such as operating leases provide as well as the ability for businesses to turn fixed assets into cash through refinancing. 

The disadvantages of asset financing include the rules and restrictions which leases entail, as well as the added risk of taking on additional debt-like contracts. A business must have the necessary free cash flow to cover these consistent outlays each month. In addition to the risks associated with finance and operating lease contracts, businesses which make use of asset refinancing arrangements may also lose ownership of the asset in question as a result of failing to consistently make interest and principal repayments. 

A prudent business owner will weigh the pros and cons of each type of arrangement to determine the relative risk of each option and its potential impacts on the ability of the business to continue operating.

Asset financing may offer the best choice for businesses that need the added flexibility of leasing arrangements or who need access to cash by converting fixed assets into current assets.