Asset Financing (Definition,Types) | How does Asset Financing Work?

Asset Financing Definition

Asset Financing refers to a ailment of loan based on the financial strength of the organization by mortgage or hypothecation of balance sheet assets which includes land & building, Vehicles, Machinery, Trade Receivables as well as short term investments where assets amount is decided into regular payment intervals of the unpaid portion of the asset along with interest.

Types of Asset Financing

Below given are the 5 different types that you should know.

#1 – Financial Lease

In Financial Lease, all rights and the obligations of the ownership is transferred to (the business) Lessee and for any duration. The value of the asset is shown on the balance sheet of the lessee as a liability or an asset during the agreement period, whereas the rent is treated as an expense and debited to Profit and loss account. Lessee is wholly responsible for the maintenance of the asset during the agreement period.

#2 – Hire Purchase

In Hire Purchase, a finance company here called lessor purchases the asset on behalf of Lessee (the business). In this option, the asset is owned by the lessor till the last payment is made and during the final payment, the lessee is given the option of purchasing the equipment at a nominal rate. The value of the asset is shown on the balance sheet of the lessee as a liability or an asset during the agreement period, whereas the rent is treated as an expense and debited to the Profit and loss account.

#3 – Operating Lease

Under this lease, the asset is taken for a short period and not for the entire working life. Here, the lessor will take back the asset at the end of the agreement and maintenance responsibility in some cases lies with the lessor or otherwise, the lessee is responsible. The asset is not shown on a balance sheet as it is for a nominated period and the payment is charged in the profit and loss account.

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#4 – Equipment Lease

Under equipment Lease, there is a contractual agreement where the owner of asset i.e. the lessor, permits the lessee to use the asset for a contracted period for which regular rentals are to be paid. Here, the ownership of equipment remains with the lessor and in case of contravention of any terms of the agreement then, the lessor has the right to cancel the lease agreement.

#5 – Asset Refinance

Under asset refinancing, assets like vehicles, buildings, etc are used to secure a loan. It’s like if the payments of loans are not done, the lender takes the asset that was secured against the loan to cover up its given amount. The amount borrowed depends on the value of the asset. Sometimes, Asset-backed lending is used for debt consolidation.

Example of Asset Financing

There is a company in the market, X ltd which is running the agricultural business. Due to an increase in the use of the agricultural product produced by the company, the demand for the same increase in the market which they were not able to meet in full. So, the management decided to increase its assets which include the new tractors and some other of the pieces of the farm machinery for increasing the production capacity.

As the business is a medium-sized business, they are not able to afford the cost of purchasing new machinery with their existing amount of funds. After exploring the several options for the financing, they decided to go for the asset financing option, as in that case they are not required to provide the extra security because the asset financed can also act as the collateral required for the financing. Also, the rate of interest in the case of asset financing is better significantly than the rate of interest in the commercial loans which was available to them.

So, in this case, the business and the asset finance provider mutually decided and agreed that asset finance provider will purchase the equipment which the business requires and the company will take the assets from them on lease over the next 48 months, paying back $ 5000,000 of the purchase costs plus the interest rate at the rate of interest of 8.5% per annum.

After deciding the terms and conditions, the asset finance provider purchased the assets and delivered the same to the business. Over the next 48 months business made regular payments for the assets. After the end of the contract, the asset finance provider offered the company to purchase the assets under lease at the nominal value. Thus this is the example of asset finance.

Advantages

The loan using asset financing is easy to obtain when compared with traditional bank loans.
Most of the agreements in case of asset financing have a fixed interest rate which is advantageous for the person borrowing the money.
In the case of asset financing, the payment gets fixed which makes it easy for the companies to prepare and manage their budgets and cash flows.
If in case the person fails to repay the amount then it leads only to the loss of the assets and nothing more.

Disadvantages

In case of asset financing, the companies even keep the important assets required for running the business for taking the loan which put them into the risk that they can lose important assets which they need for running their business
The value of assets against which the loan is secured can vary in case of asset financing. There is a possibility that the asset kept as the security is valued at the lower amount.
As the assets are kept as the security in asset financing, this method is not that effective for the purpose of securing the long term funding by any business.

Important Points

This Financing Type helps the company in getting the loan by pledging its balance sheet assets.
Some of the companies prefer to finance the assets using the asset financing option instead of the traditional financing because the financing in case of asset financing option is based on assets themselves and not on the perception of the banks and other financial institutions about the creditworthiness and the future business prospects of the company.

Conclusion

Often it is used by many companies as the solution for short-term funding such as the payment to the employees, suppliers or for financing its growth. The loan using asset financing is easy to obtain and in a more flexible way when compared with traditional bank loans. For the startups and the other growing business, it is of special importance, as it provides them an easy way for increasing their working capital. The asset finance is helpful to much business in many ways but before using it, the company should make sure that this financing option is right and suits best for its business model.