Bank Debt: Asset Lending vs Cash Flow Lending
When you or I request a loan from a bank, we’re faced with secured and unsecured loans. A secured loan gives the bank a charge over the asset you plan to purchase. So, if you buy a car using a secured loan, the bank, in effect, owns it until you repay the loan in full. An unsecured loan (normally at a higher rate) has no such charge.
Similarly in business, you can apply for funding using your assets or cash flow. Clearly, asset lending is less risky for the bank. However, many businesses don’t have the assets to secure the size of loan they need. Moreover, few businesses have the assets to back a loan anywhere near the size of what’s available if the bank approves a cash flow lending. Regarding what a bank will approve…
- For asset lending, banks typically offer a percentage of the total fixed asset value (an independent market valuation)
- For a cash flow lending, banks typically offer a multiple (x) of maintainable cash flow (FCF) or earnings (EBIT); the multiple depends on volatility and similar factors
Imagine your EBIT is $10m and, if approved, the bank will lend 4x EBIT. That’s $40m. If the same bank would lend 70% on assets, you would need almost $60m in assets to raise a similar amount. Sure, certain businesses have those assets (at market value, not book or cost), but I’d say most don’t, and most don’t want their assets encumbered anyway.
One caution, made more apparent by the GFC, is that you shouldn’t rely on the amount a bank approves as a gauge for responsible gearing levels. If you borrow 4x earnings on an earnings figure that you know isn’t sustainable, you could easily end up with negative ownership. That is, the business is worth less than the debt it owes. Credit teams can be tough, but there’s always information asymmetry; you know much more about the business than they do.
