What is Asset Financing: Overview, Importance, and Types
Asset financing can seem complicated, but it’s quite simple. But, the jargon used in the industry can be confusing, especially as some asset financing methods have terms that sound identical, abbreviated, or used interchangeably.
In this article, we will discuss everything you need to know about asset financing, including its importance, benefits, disadvantages, and differences between asset financing agreement types.
What is Asset Financing?
Asset financing, also referred to as equipment financing, allows small businesses to spread the cost of buying or leasing equipment and machinery over time. You’ll be able to free up working capital and use the money to grow your business.
Who is Asset Financing for?
Asset financing is intended for all types of businesses, including small and medium-sized enterprises (SMEs). It’s designed for businesses that need access to a high-value item that can help them grow while spreading the cost of the item throughout its life. Asset financing is offered to qualified limited companies and partnerships, sole proprietors, and public limited companies.
Benefits of Asset Financing
Minimal Upfront Costs
Asset financing is intended to minimize the upfront costs of purchasing an asset. The finance provider purchases the asset for the business before leasing it to them.
Increased Cash Flow
By distributing the cost of the asset over time, you can use spare capital for other growth goals or lay it aside for security, all while obtaining access to the equipment your company needs to compete and advance to the next level.
Assets such as industrial machinery and IT equipment can depreciate shortly, effectively lowering the asset’s value. Asset financing reduces the risks associated with depreciation since the business doesn’t bear the brunt of the asset’s decline in value.
Disadvantages of Asset Financing
You Don’t Own the Asset
One of the potential disadvantages of asset financing is that your company doesn’t own the asset outright. Therefore, you cannot sell it or use it as collateral for another loan. Although in some cases, you may be able to arrange for ownership to be transferred to you once the term expires.
Isn’t Ideal in the Short-Term
Since the lender must repay the asset’s cost and interest, asset finance terms typically for at least a year, making it unsuitable for businesses that need working capital finance for a short period.
Accidental Damage Isn’t Included
Although numerous asset finance agreements cover maintenance and management costs, accidental and preventable damage isn’t usually included. Under these conditions, the company likely has to shoulder repair or replacement expenses.
How Asset Financing Works
Asset financing works differently, depending on the method you’ll choose, as discussed below.
Types of Asset Financing
An equipment loan is a method of acquiring assets by paying in installments over time. You legally own the item once all payments are paid, but in some cases, it will appear on your balance sheet at the beginning of the term.
It’s a type of asset financing comparable to equipment leasing but simpler and possibly less flexible, in general.
Instead of renting an asset, an equipment loan is comparable to purchasing and paying in installments, similar to what a private customer usually does for a car. Normally, a 10% deposit and all applicable VAT are paid upfront.
Unlike leasing, your business owns the item with equipment loans. However, this implies that there are a few more factors to consider:
Equipment Loans Consideration
Will the asset depreciate?
First, determine whether the asset will retain its value. Depreciating items are typically leased rather than purchased. But, in relation to the next consideration below, this may be less relevant if your business needs the asset for the long term.
Do you need the asset long-term?
Another factor to consider is whether your company will require the item for the foreseeable future. If yes, equipment loans may be an excellent option. But if you only need the item for a limited period or are unsure, leasing might be the better option since it’s less risky.
When does the asset become obsolete?
Finally, you should determine whether the asset will be updated soon. For instance, having cutting-edge technology is a huge advantage in manufacturing, while having the latest transportation model may not be as important to your business.
Equipment Loans Alternative
If you require equipment financing, there are other choices besides loans. You might also consider a finance lease, a comparable long-term commitment, but you won’t own the item by the end of the term.
Operating leases are another popular option with more flexibility because they usually include regular upgrades and maintenance.
Equipment leasing is another popular option for asset financing because of the freedom and flexibility they provide. In it, the business (borrower) will enter into a contractual agreement with a lender to utilize the equipment for its business for an agreed-upon amount of time.
The business makes payments until the contractual period expires. Once the lease is up, the business can either return the leased equipment, renew the agreement, upgrade to the latest equipment, or purchase the current equipment outright.
Types of Equipment Leasing
There are two main types of equipment leasing — finance lease and operating lease. Apart from equipment loans and these two equipment leasing options, there are numerous options available to acquire new and used equipment for your business.
While specific terms apply to both types of equipment leasing, keep in mind that lenders (or ‘lessors’) will have different names and subtypes of equipment leasing, so not all of the points apply to every type of equipment lease.
Benefits of Leasing Equipment
Leasing equipment can be an effective means of obtaining access to expensive equipment that your business requires to thrive. Leasing is essentially a means of renting an asset for a defined length of time. It isn’t permanent and can aid many companies in scaling their business.
Some of the primary benefits of equipment leasing include:
- It enables you immediate access to the equipment your business needs
- You can lease almost anything
- It allows you to get your budget under control
- It helps free up other finance options
- There’s a lender for every kind of equipment
A finance lease is a kind of equipment lease in which the customer (or ‘lessee’) leases an asset for most of its useful life. It’s also referred to as a capital lease.
One primary feature of finance leases is that the customer bears most of the risks and rewards of ownership (such as maintenance expenses and value changes) but never truly owns the asset.
How do Finance Leases Work?
Finance leases feature a primary rental period during which the monthly payments will add up to the total cost of the asset plus interest (thus the other name, capital leases).
Once this primary rental period expires, the asset is usually near the end of its useful life. Typically, you’ll have three options by then:
- Continue using the asset in a secondary lease period, this time with more affordable payments
- Sell the asset and keep a portion of the proceeds
- Give the asset back to the lessor
Operating Leases and Contract Hire
What is an Operating Lease?
Operating leases are one of the most basic types of equipment leasing wherein the customer doesn’t bear the risks and rewards of asset ownership (such as maintenance costs). An operating lease is a way of renting an asset for your company over a short or slightly longer timeframe.
Why Consider Operating Leases?
Operating leases typically include some type of maintenance provision and have relatively short lease durations, giving the lessee more flexibility than finance leases.
Another indirect benefit of operating leases is that they allow regular upgrades since they’re often available in short terms. Some facilities even offer upgrades during the term.
There may also be certain benefits to utilizing operational leases and business contract hire instead of other forms of asset finance. For instance, rental payments can be deducted against profits rather than appearing as an asset on the balance sheet.
Is Contract Hire an Operating Lease?
An operating lease is a form of equipment lease in which the customer (or ‘lessee’) rents an asset for a portion of its service life. An operating lease is also known as a business contract hire in the case of commercial vehicles.
Operating Leases vs. Finance Leases
There are a few things to consider when choosing between operational and financial leases. Answering the following questions will help:
- Do you want to make a long-term commitment to one item or upgrade frequently?
- Do you want the asset to be included in your balance sheet?
- Are you willing to perform maintenance and repairs on your own?
- Will you use the item for most of its lifespan?
Asset refinancing can have various meanings depending on the situation. In general, it could refer to any of the following:
- Putting up an asset as a security or loan
- Asset finance plus (or in addition to) other types of finance
- Debt consolidation, also known as refinancing business debt
How does asset refinance work?
Refinance covered with other finance
One key benefit of refinancing is that you don’t have to own the assets outright. Instead, lenders will make you an offer based on how much equity you currently have.
Refinancing is always limited by the value of the assets used as collateral. For example, you won’t be allowed to borrow $10,000 against an asset worth only $5,000. However, you can still unlock enough cash for your requirements with enough equity in a costly item.
So, if you bought a piece of equipment through an equipment loan, you could use it to get a loan even if you still owe the lender.
Asset Refinance Example
A construction company owns a $10,000-worth machinery. The owner obtained it through an equipment loan agreement and only has $1,000 left to pay. That means he has $9,000 of equity in the item, In other words, the construction firm owns nine-tenths of the machinery, and the remaining tenth belongs to the lender.
In this case, the owner can refinance his company’s machinery up to $6,000 (or 70% of the item’s overall value). The refinance lender would pay the lender the remaining $1,000, take the charge over the asset, and lend the owner $6,000 based on the machinery’s value.
Equity: Key to Refinancing
If the company owner owned the asset outright, the arrangement would work in a similar way. However, in that instance, he’d most likely be able to raise more money against it. In the first example, the owner essentially owns an asset worth $9,000 since he has 90% equity in a $10,000 asset. In the latter scenario, he owns 100% of it, therefore, his equity is worth the entire $10,000.
The same logic applies to any asset a lender will accept as security. For example, if the company owner has a commercial property worth $500,000 and has $200,000 worth of commercial mortgage left to pay, he effectively owns an asset worth $300,000. He may be able to refinance and obtain a loan based on that value.
Summary and Key Takeaways
Asset financing allows businesses to prepare for asset investments ahead of time. It also helps them borrow money quicker by pledging assets such as inventory and accounts receivables.
It’s especially beneficial for new and expanding companies or those with frequent short-term working capital requirements. Asset financing loans are granted based on the company’s valuable assets instead of its profitability and creditworthiness.
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