The ABCs of CFLs and ABLs
The phrase “everything’s negotiable” holds especially true within the lending industry. From the coupon to the principal amount to the amortization schedule, no component of a loan fully avoids the realm of negotiation. Of course, these components all have significant tradeoffs usually related to the risk and return of the loan. A longer amortization schedule is riskier. A lower coupon necessitates a lower return. By sacrificing some element of a loan, such as the coupon, that reduces returns, a lender can and should be able to negotiate a change in some other element that reduces risk, such as a shorter amortization schedule. One method for a borrower to reduce a lender’s risk (and therefore be able to negotiate a lower rate) is to offer up some kind of asset as collateral. The two most common types of collateral are a claim on a business’s future cash flows and an asset that the company currently owns. These two types of lending are called cash flow and asset-based lending, respectively.
Cash Flow Lending
Pricing a cash flow loan involves forecasting the likelihood of cash flows using a variety of measures such as credit ratings. Cash flow lenders typically use covenants to protect themselves against management decisions that could hinder the ability of the borrower to generate cash. These covenants restrict metrics such as EV/EBITDA ratios, fixed charge coverage ratios, or debt/EBITDA levels.
Asset-based lending on the other hand, instead secures the loan by collateralizing assets such as accounts receivables, inventory, or capital equipment. Asset-based lending is usually more suitable for companies with bigger balance sheets, irregular cash flows, and tighter margins. Asset-based loans are frequently cheaper and more flexible than their cash flow based alternative due to certainty of appraisals on the value of the collateral. The flexibility and attractive price are results of lenders placing a higher value on current, less liquid assets, than on future, more liquid ones.