When in need of cash, many small business owners take the traditional route of seeking loans from banks or other financial institutions. But there is an ever-growing range of financing alternatives that many entrepreneurs are finding more attractive than conventional loans. Among these funding alternatives is asset financing.
Asset financing is not new to the financing scene. Actually, it's a big part of this industry. According to one report, the global asset-based financing market was worth about $4.5 trillion in 2020 and could reach $6.9 trillion by 2026.
Let’s talk about asset financing, how it works, its allure, and how SMBs and start-ups can leverage it for business growth:
What is asset financing, and how does it work?
Asset financing is a broad term describing any funding provided for the purchase of or against business assets. There are two main variations of asset financing: leasing and asset-based lending.
Leasing involves using external financing to secure the use of essential business resources such as vehicles, machinery, property, and electronics. In this arrangement, the lender funds the purchase of an asset and leases it to the business for a specified period. In return, the lessee pays the lender back in regular installments, usually weekly, monthly, or quarterly. The question of ownership at the end of the lease period depends on the initial agreement.
The second variation of asset financing is a borrowing approach where a business uses its existing assets, such as accounts receivables, inventory, investments, or infrastructure, to secure short-term funding. The borrower essentially pledges their balance sheet assets as collateral for credit. That may sound similar to a traditional secured bank loan, but it’s not quite the same.
While traditional lenders mainly focus on the borrower’s cash flow and business credit, asset-based lenders prioritize the collateral’s value. Also, asset-based lending requires fewer covenants with the lender, giving borrowers more flexibility and bargaining power.
Types of asset financing
Asset financing comes in five main flavors differentiated by the funding model, how the assets and payments are treated in accounting (according to the IFRS), and the ownership or termination options at the end of the deal.
1. Hire purchase
Hire purchase (HP) is the simplest and best-known type of asset financing. In an HP agreement, the lender funds the purchase of an asset for which the lessee pays back (with interest) in fixed monthly installments, sometimes with a large final balloon payment. Some vendors also agree to this type of purchase, cutting out the middleman (lender). But items bought on HP cost more than the cash price, even when purchased directly from the vendor, distributor, or manufacturer.
The lender or seller retains legal ownership of the asset until the final payment is made, after which, ownership transfers to the lessee. During this time, the asset appears on the balance sheet and is depreciated over time as an expense in the P&L statement. The purchase amount is shown as a liability, shrinking after each payment.
2. Finance lease
In a finance or capital lease, the lessor purchases the asset and transfers all the ownership rights, rewards, costs, and risks to the lessee. The lessee then pays the lessor back in installments to cover the purchase cost and interest. This is a long-term non-cancellable lease with a term stretching the entire economic lifespan of the asset in question. At the end of the lease period, the lessee can purchase the asset at a fraction of its fair market value.
In accounting terms, a finance lease is considered a debt-based loan, and the interest payments as expenses in the income statement. This means the lessee can claim tax deductions on the interest and depreciation.
3. Operating lease
This is a short-term leasing arrangement where the lessor allows a business to use a resource for a short period in exchange for fixed monthly payments. The lease term covers less than 75% of the asset’s useful life. And the lessor retains all the ownership rights, costs, rewards, and risks to the asset throughout the lease period. In this arrangement, the lessee may not purchase the asset during or at the end of the lease term.
Accounting-wise, an operating lease is treated like renting. The lease payments are simply entered among operating expenses, and since the lessee has no ownership claim over the asset, it never appears on the balance sheet.
4. Equipment lease
Equipment lease is a contractual agreement allowing the lessee to hire business equipment from the lessor under mutually agreed terms regarding payments, maintenance responsibilities, and the lease period. At the end of the tenure, the lessee can buy or return the equipment, renew the contract, extend the lease, or trade in the asset for a better or newer version.
The rental payments are treated as revenue expenses and are eligible for tax deduction. And the lessee has no ownership claim on the equipment during the lease period.
5. Asset refinancing
This is a financing method allowing businesses to borrow money against the asset they already have. Asset refinancing temporarily frees up the cash tied in existing business assets without liquidating them. Most asset-based lenders offer a value-to-loan ratio of up to 80%. But the best thing about asset refinancing is that you still get to keep and use the assets after surrendering them, and the leaseback arrangement is much simpler than a conventional loan agreement.
In asset refinancing, the lender essentially leases the business back its own assets. So, the repayments are treated as tax-deductible expenses. And the refinanced assets are pulled from the balance sheet until the final payment is made and full ownership restored.
The pros and cons of asset financing
Let’s look at the main advantages and risks associated with asset financing.
- It breaks down the cost of heavy investments into manageable chunks, conserving cash flow and simplifying budgeting.
- Options such as equipment and operating leases save the lessee from incurring depreciation risks and expenses.
- You can finance just about any asset, including additional costs such as user training, upgrades, installation, repair, and maintenance.
- Asset refinancing is an easy, fast, and convenient way to boost working capital.
- The tax benefits lower the cost of purchasing or using assets through leasing.
- Asset financing is simpler, more flexible, and accessible than typical loans.
- The biggest risk is losing ownership or access to the leased asset after failing to make the agreed payments.
- In the long run, asset financing might cost more than cash purchases, but that's the only tradeoff for the other benefits.
Getting on with asset financing
Asset financing is an affordable way to acquire the resources your business needs to grow without putting pressure on the cash flow or getting into risky debts. It’s also an ideal working capital reserve for asset-rich firms.
There is a wide range of asset financing solutions available to SMBs and start-ups. The only trick to leveraging asset financing is finding the offer that best suits your financing/asset needs and business model. That means researching several lenders to learn what’s out there. But looking up lenders and comparing multiple asset financing offers can be a huge pain, which is why we've developed Lendzero.
Lendzero is your one-stop financing marketplace. It’s an online platform that presents you with the best financing offers available to your business. And we do mean the best. Besides pre-qualifying your enterprise for potential funding solutions, we also pre-negotiate each deal with the lender to get the most favorable terms, limits, and rates. Do not settle for low-value deals; explore incredible asset financing opportunities with Lendzero today.