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 the Profit and loss accountProfit And Loss AccountThe Profit & Loss account, also known as the Income statement, is a financial statement that summarizes an organization's revenue and costs incurred during the financial period and is indicative of the company's financial performance by showing whether the company made a profit or incurred losses during that period.. Lessee is wholly responsible for the maintenance of the asset during the agreement period.
#2 – Hire Purchase
In Hire PurchaseHire PurchaseHire Purchase is a type of agreement in which the buyer of an asset chooses to pay for the asset in installments. A certain amount is paid as a down payment, and the rest is paid in installments that includes both principal and interest., a finance company here called lessor purchases the asset on behalf of Lessee (the business). In this option, the asset is owned by the lessorLessorA lessor is an individual or entity that leases out an asset such as land, house or machinery to another person or organization for a certain period. 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 sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company. as it is for a nominated period and the payment is charged in the profit and loss account.
#4 – Equipment Lease
Under equipment LeaseEquipment LeaseEquipment Lease is where the equipment owner allows another party to use it in exchange of periodic rentals with no transfer of ownership and has the right to cancel the lease right away in case of breach of the lease agreement., there is a contractual agreement where the owner of asset i.e. the lessor, permits the lesseeLesseeA Lessee, also called a Tenant, is an individual (or entity) who rents the land or property (generally immovable) from a lessor (property owner) under a legal lease agreement. 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 consolidationDebt ConsolidationDebt consolidation is a process which streamline several loans into a single one to receive the benefit of a lower interest rate. The reduced periodic payment leads to a reduction in liability..
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 leaseLeaseLeasing is an arrangement in which the asset's right is transferred to another person without transferring the ownership. In simple terms, it means giving the asset on hire or rent. The person who gives the asset is “Lessor,” the person who takes the asset on rent is “Lessee.” at the nominal value. Thus this is the example of asset finance.
- 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.
- 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.
- This Financing Type helps the company in getting the loan by pledging its balance sheet assetsBalance Sheet AssetsAssets in accounting refer to the organization's resources that hold specific economic value and facilitate business operations, meet expenses, and generate cash flow. They create the company's worth and are recorded in the balance sheet..
- 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.
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 capitalWorking CapitalWorking capital is the amount available to a company for day-to-day expenses. It's a measure of a company's liquidity, efficiency, and financial health, and it's calculated using a simple formula: "current assets (accounts receivables, cash, inventories of unfinished goods and raw materials) MINUS current liabilities (accounts payable, debt due in one year)". 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.
This has been a guide to what is Asset Financing and its definition. Here we discuss types of asset financing along with examples, advantages, and disadvantages. You can learn more about corporate finance from the following articles –