Asset Financing: Definition, How It Works, Benefits and Downsides

What is Asset Financing?

Asset financing refers to the use of a company’s balance sheet assets, including short-term investments, inventory and accounts receivable, to borrow money or get a loan. The company borrowing the funds must provide the lender with a security interest in the assets.

Understanding Asset Financing

Asset financing differs considerably from traditional financing, as the borrowing company offers some of its assets to quickly get a cash loan. A traditional financing arrangement, such as a project-based loan would involve a longer process including business planning, projections, and so on. Asset financing is most often used when a borrower needs a short-term cash loan or working capital. In most cases, the borrowing company using asset financing pledges its accounts receivable; however, the use of inventory assets in the borrowing process—known as warehouse financing—is not uncommon.

The Difference Between Asset Financing and Asset-Based Lending

At a basic level, asset financing and asset-based lending are terms that essentially refer to the same thing, with a slight difference. With asset-based lending, when an individual borrows money to buy a home or a car, the house or the vehicle serves as collateral for the loan. If the loan is not then repaid in the specified time period, it falls into default, and the lender may then seize the car or the house and sell it in order to pay off the amount of the loan. The same concept applies to businesses buying assets. With asset financing, if other assets are used to help the individual qualify for the loan, they are generally not considered direct collateral on the amount of the loan. The lender may include a covenant as part of the loan contract that bans the borrower from using pledged assets to secure other loans.

Asset financing is typically used by businesses, which tend to borrow against assets they currently own. Accounts receivable, inventory, machinery, and even buildings and warehouses may be offered as collateral on a loan. These loans are almost always used for short-term funding needs, such as cash to pay employee wages or to purchase the raw materials that are needed to produce the goods that are sold. So, the company is not purchasing a new asset but using its owned assets to make up a working cash flow shortfall. If, however, the company goes on to default, the lender can still seize assets and attempt to sell them to recoup the loan amount.

Secured and Unsecured Loans in Asset Financing

Asset financing, in the past, was generally considered a last-resort type of financing; however, the stigma around this source of funding has lessened over time. This is primarily true for small companies, startups and other companies that lack the track record or credit rating to qualify for alternative funding sources.

There are two basic types of loans that may be given. The most traditional type is a secured loan, wherein a company borrows, pledging an asset against the debt. The lender considers the value of the asset pledged instead of looking at the creditworthiness of the company overall. If the loan is not repaid, the lender may seize the asset that was pledged against the debt. Unsecured loans do not involve collateral specifically; however, the lender may have a general claim on the company’s assets if repayment is not made. If the company goes bankrupt, secured creditors typically receive a greater proportion of their claims. As a result, secured loans usually have a lower interest rate, making them more attractive to companies in need of asset financing.