In recent years there has been a significant growth in the use of more alternative forms of business finance to acquire high-value equipment (e.g. machinery, computer systems, vehicles). Among these, asset finance has arguably become the most prevalent, with asset finance companies in 2017 alone providing more than £32 billion to UK businesses in the form of asset finance. Particularly with SME’s, there has been a surge of businesses choosing to use asset finance instead of purchasing equipment outright.
What is asset finance?
In simple terms, asset finance is used by businesses to attain equipment of a high value they require to achieve growth.
In practice, this means (also known as machinery finance or equipment finance) an asset finance provider will purchase equipment outright on behalf of a business, in the turn the business agrees to lease or rent the equipment for a certain period. The business then makes regular use payments over the agreed period (usually the usable life of the equipment). The financier also typically agrees to insure and maintain the asset over its lifespan.
Who is asset financing for?
Asset finance is relevant for any business of any size which is considering purchasing high-value equipment needed to support their continuing growth. In addition, asset financing is very useful for a business who is unable to raise the funding needed to purchase such equipment outright or would like to the spread the cost the equipment (asset) over its usable life. Asset finance is also suitable for all business structures including Limited Companies, Sole Traders, Limited Partnerships, Public Limited Companies.
How much can businesses raise from asset finance?
The majority of asset finance providers/brokers can provide / source between £1,000 to £10,000,000 in financing. Asset finance is typically provided between 1 and 7 years (in rare cases longer for extremely high-value assets), this period allows the finance company enough time to recoup the purchase cost of the equipment plus interest.
The length of financing is determined by the usable life of the asset and how long the financier is willing to allow for full payment to take place (usually calculated on the acceptable level of risk and profit/interest allowed by a particular provider). Additionally, to gain asset financing, it is extremely important to a financier when considering approving an asset financing contract that a business can demonstrate its ability to make the regular payments agreed to (the payments are affordable for the business).
An example of asset financing
To illustrate the above here’s an example of asset finance in practice:
A medium-sized agricultural business requires new tractors and several pieces of farm machinery to increase production capacity. This new equipment is required as they have seen a significant and continuing increase in demand for their products over the past year and are now unable to meet demand. The business is unable to afford the cost of buying the new machinery with retained funds (cash at the bank). They explore several financing options and decide asset finance would be the best fit as they aren’t required to provide security (the asset financed acts as collateral), and the rate of interest is significantly better than commercial loans available to them.
The business agrees with an asset finance provider that if they purchase the equipment needed, the business will lease the equipment from them over the next 64 months, paying back £382,000 in purchase costs plus interest. The provider then purchases and delivers the machinery and tractors needed to the business and within 72 hours. Over the next 64 months the business makes regular payments on the equipment, at the end of the contract the business is offered to purchase the equipment it has been leasing at a nominal value, they choose to do. This example is a type of asset finance called higher purchase.
Types of asset finance
Principally there are 3 different types of asset finance available to businesses. This includes Hire Purchase, Finance Lease and Operating Lease (there are also several other types of more specialised asset finance).
With Hire Purchase, the business agrees to lease an asset from an asset finance provider, who in turn agrees to purchase and provide the asset for the business to lease. During the leasing period, the asset is owned by the provider (who is responsible for insurance and maintenance), and the business makes regular payments to the provider for the use of this asset. At the end of the leasing period, the business takes ownership of the asset.
A Hire purchase agreement will typically allow a business to structure the payments flexibly to minimise cash flow impact from payments. For instance; A business could reduce the monthly/quarterly rental payment by agreeing on a large final payment at the end of the leasing period (known as a balloon payment, it takes into account the residual value of the asset at the end of the leasing period).
Additionally, from an accounting point of view, during the lease period, the asset will be listed on the business’s balance sheet as both an asset and a liability, with the leasing cost (rental) being shown as an expense of the business and passed through the P&L (Profit and Loss) account.
With a Finance Lease, a business and an asset financing provider agree that the provider will purchase an asset outright for the business, who in turn agrees to lease the asset over a fixed period, with the business providing a regular payment for the use of the asset over this period. At the end of the leasing period, the provider sells the asset with the business and provider generally both benefiting the from the sale of the asset (i.e. the business receives a reduction in final payment or a cash payout).
A Finance Lease differs to higher purchase as, during the leasing period, the business is given full ownership and responsibility for the asset when the lease begins, meaning they’re fully responsible for the asset (insurance, maintenance costs…). Additionally, there is never any intention or mechanism that allows the business leasing to gain ownership after the leasing period has ended, even at the point where the asset has reached the end of its usable life (the intention is always to sell unless the agreement is modified).
An Operating Lease is most suitable for businesses where they will not need the asset for the entirety of its working life. It is a more specialised version of a Finance Lease designed for businesses which as per above do not seek the asset for its working life and require the asset to service a new or existing contract the business has.
Operating leases offer benefit over Finance Leasing in the situation above, as the base rental costs are calculated on the value of the asset over the period you’ve agreed to lease it for (your rental cost is not based on the full value of the asset, significantly reducing the cost to the business). Operating Leases also allow businesses to directly associate rental to revenue generated by the assets your leasing.
As with a Finance Lease for the leasing period, the business typically takes ownership of the asset (meaning the business has responsibility for the maintenance/insurance costs, however in some cases, this can be shouldered by the provider if agreed).
Other types of asset finance
As well as the three primary types of asset finance, there a range of more specialised asset financing options, some are variations designed to offer more flexibility of existing asset finance types, some are designed to finance specific types of assets or sectors. We’ve detailed the most common these types below.
Contract Hire is a more specialised of Operating Lease; it is exclusively used for the leasing of vehicles (often referred to as vehicle asset finance). In a Contract Hire situation, a business will approach an asset finance company looking to attain a vehicle or many vehicles. The asset finance company will then source and provide the vehicle/s to the business and also provide maintenance and disposal of the vehicle asset/s when the end of the leasing period happens (fleet management may also be included as part of the agreement.)
The advantages of Contract Hire are that businesses do not have the burden of sourcing the vehicle, the provider takes responsibility for the care of the vehicle, and the provider can usually get a better price through an existing supplier network than the business could achieve when purchasing the vehicle.
Refinance although residing within the area of asset finance, can more specifically be defined as a form of asset-based lending. Refinance is when a business agrees to sell an asset/s to an asset finance provider, who in turn provides a lump sum to the business to purchase the asset/s.
In turn, the business agrees to lease back the asset they have just sold and provide regular use payments plus interest to the asset finance provider (paying back the initial lump sum paid). Refinance allows businesses who are asset rich and require capital to quickly raise large sums from their existing assets, without giving up the use of these assets. It can be particularly useful for businesses who have experienced a downturn and require a large cash injection but cannot afford to relinquish their existing assets.
It can also be a useful form of finance for businesses who have poor credit or financial history and have been turned down for other forms of finance such as commercial loans. This is because the asset finance provider will base the lending on the value of the asset, not any previous financial records.
What assets can be financed?
The majority of assets of physical assets with a high value can be financed but must meet certain basic industry criteria of being durable, identifiable, movable and saleable (DIMS for short).
This criteria effectively acts as a basic litmus test for asset financiers to determine whether an asset is appropriate for financing (with the aim of reducing the risk for the financier). However, in recent years the DIMS framework and the perception of what constitutes an asset has become more flexible, with a larger range of providers offering finance on assets that traditionally would not have been viewed as appropriate for asset finance (i.e. software). When it comes to asset financing, there are now two broad categories of assets that are financed; this includes soft and hard assets.
Hard Assets are physical items of high value. Examples of Hard Assets include agricultural machinery, heavy goods vehicles, printing presses, recycling processors, CNC controls for machine lines, manufacturing systems and equipment, production and plant equipment, construction vehicles, light goods vehicles and mining equipment.
Hard Assets act as reliable security for financiers as they provide a significant amount of security in their sizeable and continuing value even at the end of their usable life. In particular hard assets that are revenue producing can retain significant value for long periods (i.e. manufacturing equipment). The majority of asset financing provided is for hard assets, in particular, hard assets that meet the criteria of the DIMMS framework.
Soft assets are assets with little or no second-hand value when they come to the end of their usable life (the end of the leasing period). Examples of soft assets include information Technology (hardware & software), office furniture, medical devices, air conditioning systems, security systems (including CCTV), Electronic point of sale (EPOS) systems
Soft Assets reduce the security the asset can offer against the finance being provided, making soft assets a much riskier proposition to finance. To counter this increased risk, asset finance providers tend to base financing decisions on several different factors current/projected situation of the business (ability to payback). They also usually require some form of additional security to offset the risk, this might be a director’s guarantee, another asset as collateral or an upfront deposit of up 20% on the value of the asset.
Can second-hand equipment be financed?
Yes, asset financing is typically available to acquire used equipment (i.e. refurbished IT equipment). This because financiers understand that in many situations with larger equipment purchases that purchasing new might not be the best investment for them or you (although sometimes it is), thus they are flexible when purchasing new or old equipment and instead focus on the condition, remaining usable life and suppler provenance when agreeing to purchase an asset.
Advantages of asset finance
Asset finance depending on the business circumstances can offer a significant amount of advantage over more traditional forms of finance (i.e. commercial and business loans) in regards to large asset and equipment purchases.
Significantly reduces the upfront cost
Asset finance lends itself particularly well to significantly reducing the large upfront costs associated with large capital purchases (such as equipment). This is because instead of a business buying an asset outright in cash, the asset finance provider will purchase the asset on the business’s behalf (shouldering the upfront cost) and then lease to the business for a regular usage payment.
Many types of asset suffer from radical depreciation over a relatively short time frame (i.e. such as industrial machinery, commercial vehicles and information technology systems).
Depreciation quickly reduces the value of the asset and thus the security for the business (it’s unlikely a business can recoup near its original investment if the asset has to be sold). Many assets can lose close to third of their value even after the first purchase day, as they become labelled second-hand equipment (a good example of this is vehicles, in particular, cars). If the asset does not last as long as expected and depreciation is more rapid, it can also create a serious cost implication for the business (needing to pay for a replacement earlier than planned).
Asset finance alleviates the risks associated with depreciation as in most cases the business is not the owner of the asset, the provider is the owner and thus takes responsibility for bearing any unexpected loss in value or replacing the asset as needed (if it fails to survive the duration of the agreement).
By avoiding large upfront purchasing costs, asset finance frees up businesses to redeploy capital elsewhere. Businesses get the best of both worlds, getting the use of needed assets but without the initial capital commitment, making available funds to support other growth activities or be kept aside for security, flexibility or to take advantage of future growth opportunities that require investment.
No unexpected costs
Asset finance providers are responsible for any management, maintenance and disposal concerning the asset (depending on your agreement/type of asset financing used). This protects businesses from any unforeseen costs required to keep the asset running or dispose of it.
Additional credit line
Asset finance can act as a useful additional form of credit for your business, when you’re unable to or don’t wish to extend existing facilities such as bank loans and overdrafts (in particular with allowing you to avoid the typically higher interest rates associated with overdraft and commercial loan products).
Little or no security required
If a business is in immediate need of high-value equipment critical to growth, doesn’t have the retained funds and can’t access the traditional forms of finance needed to make the purchase, asset finance can help.
In most cases, the asset is enough security for the asset finance provider to sign off on providing the financing (in some cases deposits are required though). Where traditional lenders are unable to assist, asset finance offers a secure way for a business to attain the asset they need while giving relatively security from ownership to the financier.
Improve your cash flow
For most types of asset finance, a business will make regular structured payments throughout the usable life of the asset. This allows businesses to spread the cost of the asset throughout its usable life as a result, improving cash flow and increasing the amount of working capital available at any time. With many such financing agreements a business can also agree with a provider to fix interest rates, dispensing with any unpredictable costs from an increase in rates).
Disadvantages of asset finance
While being a very flexible form of alternative finance, asset finance like any other form of finance has its disadvantages and limitations.
Lack of ownership
Asset finance provides no long-term ownership of the asset to the business. This is opposed to more traditional financing options such as a commercial loan, where you would borrow money to purchase a high-value asset and in doing so gain ownership of the asset.
Asset finance means you are leasing or renting the asset (continually paying to use an asset), gaining no ownership of the asset in exchange for the payments you’ve made (unless otherwise agreed, i.e. a buyout or ownership transfer option at the end of asset life). The lack of ownership means the business won’t be able to sell the asset if needed to raise funds or use it as security to gain other financing. Thus, asset finance in reduces the flexibility and security the business receives from the asset.
Not a short-term financial solution
Asset finance is designed to work for longer periods; this enables the financier time to recoup the original cost of the asset purchase plus interest. For this reason, asset financing agreements are rarely agreed to for less than a year and in most cases much longer.
Thus, there is not really any short-term asset finance available. For those businesses who are seeking short-term working capital, asset finance isn’t an option.
Accidental damage may not be covered
Many asset finance agreements will cover maintenance costs and management (including general maintenance), but depending on the agreement in many cases damage to the asset that is deemed as accidental or preventable is not covered by the financier and instead the onus is put on the business leasing the asset to pay for any repair for replacement.
Frequently asked questions about Asset Finance
When it comes to asset finance, there are often several niche questions that go unanswered, below we’ve covered the frequently asked of questions and the answers to them.
Can capital allowances be applied towards asset finance?
Yes and no, the HMRC currently capital allowances can be applied against certain assets businesses attain through asset financing, providing a certain proportion of tax relief on a business’s profits over the course of an accounting year against applicable assets (reducing your tax bill on taxable profits). Eligible assets for capital allowances are covered in three main categories, being equipment, machinery and business vehicles.
Can I finance my existing assets owned?
Yes, in many cases businesses can sell your assets to a financing company and agree to lease them back, this is called refinancing, detailed further in the types of asset finance section. It can be an extremely useful way for businesses generate large sums of capital quickly to deal with unexpected costs or deploy for new growth opportunities (while retaining use of the asset).
What businesses use asset finance?
Traditionally asset financing had only been available / used by large businesses and corporations for financing equipment of significant value. However, as awareness, the number of independent asset financing companies and the minimum level of finance available has significantly decreased, so has the demand for and use of asset finance by small and medium-sized businesses. It’s important to note however some financing companies will only work with businesses of a certain type (i.e. Limited Company, PLC) and provide funding to a higher minimum.
Further examples of asset financing
Below you’ll find three further working examples of asset finance:
Example 1: A large FMCG (Fast Market Consumer Goods) company requires a new fleet of vehicles to enable its growing regional sales teams to travel during business hours. The company does have the funding available to purchase a new fleet of vehicles but prefers to avoid the initial purchase cost and the associated management/maintenance fee. They enter into an asset financing agreement with their bank to rent the fleet of vehicles they require, the bank, in turn, purchases the vehicles and rents them back to the company for a period of 3 years. The bank is responsible for management and maintenance fees, the resulting freed up capital allows the business to invest in other areas of the business to support growth.
Example 2: A small manufacturing business who has recently expanded its client’s base outside of Europe is facing unexpected demand and requires finance quickly to purchase a new plant and equipment needed to meet the increased demand. The manufacturing business has currently little or no funding in reserve to purchase the needed equipment but wish to gain the benefit of having the equipment now and spread the cost of the equipment over its usable lifespan. The business does not have any major assets to act as security but presents its plan and the current demand situation to the financier. The financier agrees the growth and demand are promising and approves the asset finance deal over 48 months. The financier uses the equipment they will purchase to lease to the business as the security for the agreement. This allows them to quickly approve finance to a promising company in a growth situation where traditional lending or asset lending products would likely have not been authorised, due to the lack of collateral the business could provide.
Example 3: A coach travel business requires vehicle asset finance to free up capital from their fairly new fleet of vehicles (coaches). This capital will be used to take advantage of an unexpected opportunity to purchase a competitor at a lower than market value price. They decide that a business loan would be too much of a risk in financing the deal (given the high-interest rates). In order to move forward and finance the deal they agree with a commercial asset finance company to sell their fleet of vehicles to the financier and lease back the vehicles for the remainder of their usable life of 72 months (longer than the traditional type of asset finance but this can happen when assets have a long-life cycle). This is called asset refinancing; it allows a business to quickly free up capital stuck in an existing asset while retaining use of the asset.