Whether a company is a startup or a 200-year-old conglomerate like E. I. du Pont de Nemours and Company (DD), it relies on borrowed capital to operate the way that an automobile runs on gasoline.

When a company borrows money from a bank or another institution to fund its operations, acquire another company or engage in another major purchase, it will likely finance the loan through one of two primary lending methods: cash flow or asset-based. Cash flow-based lending allows individuals or companies to borrow money based on the projected future cash flows of a company, while asset-based lending allows them to borrow money based on the liquidation value of assets on its balance sheet. (For more, see: How Advisors Can Help Clients with Cash Flow Issues.)

We look at cash flow-based lending and asset-based lending, the advantages and disadvantages of both options, and the scenarios where one is the more preferred method to the other. (For more, see: What is the difference between asset-based lending and asset financing?)

Cash-Flow Lending

In cash-flow lending, a financial institution grants a loan that is backed by the recipient’s personal or business cash flows. By definition, this means that a company borrows money from expected revenues they anticipate they will receive in the future. Credit ratings are far more important in this form of lending, in addition to historical cash flows.

For example, a company that is attempting to meet its payroll obligations might use cash-flow finance to pay its employees now and payback the loan and any interest on the profits and revenues generated by the employees on a future date. These loans do not require any type of physical collateral like property or assets. Instead, these lenders examine expected future company incomes, its credit rating and its enterprise value.

The advantage to this method is that a company can obtain financing much faster, as an appraisal of collateral is not required.

Institutions underwrite cash flow-based loans by determining credit capacity. Typically, they will use EBITDA (a company’s earnings before interest, taxes, depreciation, and amortization) along with a credit multiplier to calculate this figure. This financing method enables lenders to account for any risk brought on by sector and economic cycles. During an economic downturn, many companies will see a decline in their EBITDA, while the risk multiplier used by the bank will also decline. The combination of these two declining numbers will reduce the available credit capacity for an organization.

Cash-flow loans are better suited to companies that maintain high margins on their balance sheets or lack enough in hard assets to offer as collateral.

Companies that meet these qualities include service companies, marketing firms and manufacturers of low-margin products. Interest rates for these loans are typically higher than the alternative due to the lack of physical collateral that can be obtained by the lender in the event of default.

Asset Based Lending

Asset-based lending comprises business loan secured by the liquidation value of their assets. A recipient receives this form of financing by offering inventory, accounts receivable and/or other balance-sheet assets as collateral. While cash flows (particularly those tied to any physical assets) are considered when providing this loan, they are secondary as a determining factor.

Common assets that are provided as collateral for a capital loan include physical assets like real estate, such as land and physical properties, company inventory and manufacturing equipment, or physical commodities. If the borrower fails to repay the loan or defaults, the lending bank can seize the collateral and sell the assets in order to recoup its loan amount.

Asset-based lending is better suited for organizations that have large balance sheets and lower EBITDA margins. They are also companies that require capital to operate and grow, particularly in industries that might not provide significant cash flow potential. An asset-based loan can provide a company the needed capital to address its lack of rapid growth.

Depending on a company’s credit rating, they might be able to borrow anywhere from 75% to 90% of the face value of their accounts receivable line on the balance sheet. Firms with weaker credit ratings might only be able to obtain 60% to 75% of this face value, according to authors William Bygrave and Andrew Zacharakis. However, when providing physical inventory or manufacturing equipment as potential collateral, the borrowing amount might be less than 50% of the perceived value of the assets. The reason for this is because these assets might be sold through liquidation or auction, and the lender might need to sell these assets quickly in order to obtain its loan back.

Asset-based loans maintain a very strict set of rules regarding the collateral status of the physical assets being used to obtain a loan. Above all else, no company or individual may offer these assets as a form or collateral to other lenders. Should these assets be pledged to another lender, this former loan provider must subordinate their position to obtain the assets. Finally, the company obtaining the loan must address any accounting, tax, or legal issues prior to an agreement. Such concerns could affect the lender's ability to secure and sell the asset in liquidation.

Prior to authorizing a loan, lenders require a relatively lengthy due diligence process, which includes the inspection of the balance sheet, ledgers and assets to calculate the value of a company’s allowable borrowing capacity. Costs associated with this analysis vary, but common charges include site visits, collateral evaluations and interest costs.

The Bottom Line

When a company or individual needs a loan in order to conduct short-term or long-term business, they have two primary options to borrow money. These two types of loans have a variety of different qualities. Cash-flow lending has a higher emphasis on the credit rating of a person or organization and expected cash in-flows to the balance sheet. Meanwhile, investors with lower cash flows, weaker credit ratings or robust accounts receivable lines on their balance sheet might obtain financing through an asset-based loan. However, the assets’ values typically must have significant value in order for a lender to take the risk. (For more, see: Introduction to Loans section of the Complete Guide to Corporate Finance.)