Asset finance refers to the use of a company’s assets to borrow money. The company borrowing the funds must provide the lender with a security interest over the assets. Assets may include items as large as ships, airplanes or trains, or as small as machine tools and films.
As well as any relevant accounting and tax issues, it is important that you understand the legal implications involved in asset financing by taking advice from a specialist finance solicitor.
In this article we will be covering:
- What is asset finance and how does it work?
- Who is asset financing for?
- Which of your assets can be financed (or refinanced)?
- What are the minimum and maximum amounts that can be borrowed?
- What’s the difference between hard assets and softs assets?
- Can any of your second-hand assets be financed?
- What is secured lending in asset finance?
- What is leasing in asset finance?
- What is hire purchase agreement in asset finance?
- What is refinancing in asset finance?
- What is securitisation?
- Key issues in asset finance
- What are the advantages of asset finance for businesses?
- What are the disadvantages of asset finance for businesses?
What is asset finance and how does it work?
Asset finance is where a lender agrees to extend a loan in return for taking security over a company’s assets. The financing may be based on a single asset (e.g. a ship) or a whole series of assets (e.g. a fleet of ships).
Asset finance is a broad field and may cover lending against existing assets or to obtain new assets.
Asset finance includes:
- Equipment leasing
- Finance leases
- Hire purchase
- Operating leases
- Asset refinance
Who is asset financing for?
Asset finance is appropriate for any business looking to acquire assets in order to grow and operate more efficiently. It may be appropriate for a wide range of businesses including sole traders and small to medium sized enterprises, as well as larger companies.
Asset finance can be used to acquire equipment, machinery and even vehicles. It may also be used to release cash that is tied up in assets already owned (known as a refinance). Asset finance can help spread the cost of high value items and the fixed payments may make it easier for a business to budget for.
Which of your assets can be financed (or refinanced)?
Any asset can be financed if it is acceptable security to the lender. Historically, the asset finance industry would finance anything that was Durable, Identifiable, Moveable and Saleable (DIMS). Although modern lenders may take a broader view on the kinds of assets that can be financed.
The range of assets involved in asset finance is extremely broad and range from agricultural machinery to Xerox machines.
Key considerations for a lender include:
- The location of the asset
- The earning potential of the asset
- The resale value of the asset
- Legal formalities for taking security over the asset
What are the minimum and maximum amounts that can be borrowed?
Limits on borrowing vary from lender to lender but it is not uncommon to see asset finance raise sums as small as £1,000 to as much as £10 million.
What’s the difference between hard assets and softs assets?
Hard assets are physical assets that are durable in a nature. They include high-value items such as machinery, plant, equipment and vehicles. Buildings and warehouses may also be considered hard assets for the purposes of asset finance.
In contrast, soft assets are assets that are less durable in nature. Soft assets include things such as furniture, software, IT equipment and electronics, or any equipment with a limited lifespan.
Can any of your second-hand assets be financed?
Yes. Asset finance lenders may consider used equipment for financing. An asset finance provider will wish to establish that the equipment is worth the value attributed to it and that it is in good working order.
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What is secured lending in asset finance?
Secured lending in asset finance is where a lender provides a loan to the prospective owner/operator of an asset to finance its acquisition of the asset. The lender will take security over the asset as part of the loan.
Funding may come from a traditional bank or from another type of finance entity. It is also possible that funding comes from a capital markets debt offering.
Since 1 January 2019, IFRS 16 (the accounting standard) has eliminated the balance sheet distinction between an operating lease and a finance lease. Previously an asset appeared on the owner’s balance sheet in an operating lease and on the operator’s balance sheet in a finance lease. From 1 January 2019, all leases are to be reported on the operator’s (the lessee's) balance sheet as assets and liabilities, subject to limited exemptions.
What is leasing in asset finance?
Leasing in asset finance involves the owner of an asset leasing it to an operator. The borrower does not necessarily become the owner of the asset but will use the asset for its business.
There are two primary forms of lease used in asset finance transactions:
- Finance leases
- Operating leases
Under a finance lease, the owner leases the asset to the operator. The operator in return pays rent to the owner. This rent is calculated so that at the end of the lease, the operator will have repaid the owner’s cost of acquiring the asset. Once the lease ends, the operator is regarded as having the economic ownership of the asset, including any residual value.
Under an operating lease, the operator rents the property from the owner but does not take ownership of the asset at the end of the lease. The owner instead retains the risks and rewards of owning the asset. A common example of operating leases is charter airlines who lease extra aircraft during the summer holiday season. The airlines rent the airplanes without ever taking full ownership of the aircraft.
What is hire purchase agreement in asset finance?
A hire purchase agreement is a type of lease agreement with an option (but not an obligation) for the operator to own the asset at the end of the hire period.
Under a hire purchase agreement, the borrower will pay the lender an initial deposit, which represents a substantial part of the purchase price. The borrower then makes periodic payments (typically monthly) up to an agreed amount. Once all of the instalments have been paid, the borrower has the option to buy the asset for an extra fee.
Consumer hire purchase agreements are regulated by the Consumer Credit Act 1974. The Consumer Credit Act provides protection and remedies to debtors and hirers under certain circumstances.
What is refinancing in asset finance?
Asset refinance is where a company releases capital by borrowing against assets that it already owns. As with conventional asset finance, once a business asset is refinanced, the business makes agreed monthly payments over the course of the contract, plus any interest payments.
Asset refinance can offer a way for businesses to free up working capital on assets that they are already using.
What is securitisation?
Securitisation is the process of pooling together assets and selling their cash flow to investors. Common assets used in securitisations include residential mortgages, commercial mortgages, auto loans and credit card debt.
In a typical ‘true sale’ securitisation transaction, a company sells its cash generating assets to investors via a special purpose vehicle.
First, a special purpose company is created that sells debt securities to investors. This new company then uses this money to buy the assets from the owner (known as the ‘originator’). Any money received from the assets (such as mortgage payments) after it has acquired the assets are then paid to investors as interest payments for the debt securities that they own. The economic effect of a securitisation is to transfer the cash flow from the assets to debt investors.
The securities sold by the special purpose vehicle are commonly divided into different classes (‘tranches’) with different priorities for the payment of principal and interest. Each tranche will generally be given a credit rating depending on how risky the assets are deemed to be by a credit ratings agency. This ensures that the securities can be sold to the widest possible range of investors, as certain investors are prohibited from acquiring assets below set credit rating levels.
Key issues in asset finance
A key concern for lenders in asset finance is maintaining the value of the asset. Under a finance lease, a lender will take repossession of the asset if the operator defaults on its payments. It will therefore want to make sure that the value of the asset is sufficient to cover any outstanding payments.
Under an operating lease, a lender will retain the economic ownership of the asset. The lender will therefore want to ensure that the asset retains its value and is marketable to future operators or buyers.
Under the lease agreement, the borrower will agree to restrict its use and operation of the asset to the prescribed terms. The lender will also want to make sure that the borrower acquires to a minimum standard of maintenance and keeps the asset fully insured at all times.
By contrast, an operator will want as much operational freedom as possible. An operator will not want its maintenance obligations to interfere with the running of its business.
The exact terms of the lease are a matter for negotiation but common promises include:
- How the asset is maintained and repaired
- The operator’s right to ‘quiet enjoyment’ of the asset
- Restrictions on sub-leasing the asset
- The condition in which the assets should be returned to the owner
What are the advantages of asset finance for businesses?
Asset finance may provide some of the following advantages to businesses:
- Small or no upfront costs when purchasing high-value items
- Spreading the cost of the item over several payments
- Fixed payments make budgeting for regular payments easier
- Preserves capital for ordinary business purposes
- Risk of deprivation in the value of the asset fails on the lender
What are the disadvantages of asset finance for businesses?
Failure to keep up payments on an asset finance contract can result in a lender taking possession of the company’s equipment, which may pose a serious risk to a business. Many asset finance arrangements are long-term commitments and require businesses to sign up for at least a year. Payments under an asset finance arrangement are likely to be higher than the cost of buying the equipment outright.