Asset Financing Definition Types How Does Asset Financing Work

Asset Financing Definition

Types of Asset Financing

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

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#1 – Financial Lease

In Financial Lease, all rights and the obligations of the owners are transferred to (the business) Lessee and for any duration. Lessee is wholly responsible for the maintenance of the asset during the agreement period. The asset’s value is shown on the lessee’s balance sheet as a liability or an asset during the agreement period. In contrast, the rent is treated as an expense and debited to theProfit 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.read more.

#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.read more, 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.read more 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 asset’s value is shown on the lessee’s balance sheet as a liability or an asset during the agreement period. In contrast, 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, 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.read more 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.read more, there is a contractual agreement where the asset owner, 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. read more 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 infringement of any terms of the agreement, 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. If the loans are not made, 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.read more.

Example of Asset Financing

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

As the business is a medium-sized business, they cannot afford the cost of purchasing new machinery with their existing amount of funds. After exploring several options for financing, they decided to go for the asset financing option. 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 significantly better than the rate of interest in the commercial loansCommercial LoansCommercial loans are short-term loans used to raise a company’s working capital and meet heavy expenses and operational costs. It is a kind of financing often used by small companies that cannot afford to raise money from equity markets and bonds. Banks and well-established financial institutions often provide commercial loans against the debtor’s financial statements and credit score.read more available to them.

So, in this case, the business and the asset finance provider mutually decided and agreed that the asset finance provider would purchase the equipment the business requires. 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 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 the 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.”read more at the nominal value. Thus this is an example of asset finance.

Advantages

The loan using asset financing is easy to obtain compared to traditional bank loans.Most of the agreements in the case of asset financing have a fixed interest rateFixed Interest RateA fixed interest rate is a constant rate of interest levied on debts like loans, mortgages, or bonds.read more 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 the person fails to repay the amount, it leads only to the loss of the assets and nothing more.

Disadvantages

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

Important Points

This Financing Type helps the company get the loan by pledging itsAssets 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.read more 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.read more.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 creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan.read more and the future business prospects of the company.

Conclusion

Asset finance is helpful to many businesses in many ways. Often it is used by many companies as the solution for short-term funding, such as the payment to the employees, suppliers, or financing its growth. The loan using asset financing is easy to obtain and more flexible when compared with traditional bank loans. It is of special importance for startups and other growing businesses, as it provides them an easy way to increase 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)“read more. Still, before using it, the company should ensure that this financing option is right and best suits its business model.