What’s better: cash flow or asset-based borrowing?
Many CEOs believe the amount of reasonably priced senior capital their company can obtain is limited by what hard assets they have as collateral, such as inventory, receivables, machinery and equipment. But that is no longer true.
Over the last two decades, businesses have become less dependent on owning hard assets. The predominant indicators of a company’s health today include highly skilled talent, technology investment, good customer experience and provision of services. Even for asset-heavy businesses, the difference between success and failure usually comes down to having the people, strategies, processes, systems and technologies to beat the competition.
Recognizing this, firms that participate in private capital markets have developed a deep and flexible toolkit for providing capital to companies. The question is, how do companies know when to pursue cash flow lending versus asset-based borrowing?
Factors hinging on lending options
Commercial banks tend to be more focused on assets. Their basis for lending depends on sufficient collateral. In other words, if the borrower has to liquidate, the loans will be paid. In the absence of asset collateral, banks catering to lower middle-market borrowers often seek personal guaranties as a secondary source of repayment.
Non-bank commercial lenders — also called direct lenders — and a small but growing community of commercial banks are increasingly enterprise-based in their investment analyses. Direct lenders consider EBITDA, adjusted EBITDA and cash flow available for debt service. They also examine the quality and consistency of a company’s earnings.
Comparing asset-based and cash flow lending
Traditional asset-based lending is still the least expensive. For smaller companies, it may be the only form of senior capital available. A company needs to pass $3 million in EBITDA before private capital market participants want to talk.
Here are some differences between asset-based and cash flow borrowing:
- Cost: Cash flow borrowing can have interest rates two to four percent higher than asset-backed loans.
- Available capital: Commercial banks and asset-backed lenders are usually limited to fixed percentages of available collateral. This typically tops out at three times EBITDA. Cash flow lenders can go up to four-and-a-half times EBITDA on senior debt.
- Amortization: Banks will generally require a minimum of 10 percent fixed annual amortization or more. Cash flow lenders can create amortization schedules that are flexible and may be as low as 1-5% annually.
Choosing the right solution
There is no one-size-fits-all solution. For many companies, a blend of asset-based and cash flow borrowing will create an optimal outcome. For others, it’s better to pursue very low-cost asset-based borrowing.
If you’re running a healthy company whose success and profitability are not based on hard assets, cash flow borrowing may provide you with more capital at a lower cost. In fact, if you are considering growth investments or buying out partners, you may want to consider this option carefully.
Category: Capital / Cash Management
Tags: Economy, Management