Asset finance – what is it and how does it work?

An in-depth guide on asset finance and its benefits

What is Asset Finance?

Every year, UK businesses small and large cumulatively spend billions on the equipment they need to operate. If a machine is business critical, purchasing and owning it seems like a natural instinct.

But equipment costs a lot, and buying it means waiting until you’ve retained enough cash, or financed the purchase through a traditional loan. You take on more debt, add to capex, or both.

In today’s economy, outright ownership can be an expensive proposition. That’s why so many businesses now look to asset finance

From vehicles to IT hardware and office photocopiers, physical assets depreciate in value – sometimes quickly. They need to be insured and maintained. And as the pace of competition, innovation and regulatory change accelerates, business equipment needs to be frequently updated and upgraded – if not replaced entirely.

In today’s economy, outright ownership can be an expensive proposition. That’s why so many businesses now look to asset finance as the best way to obtain and maintain the equipment they need to grow.

What is asset finance?

In asset finance agreements a lender purchases equipment on behalf of a client (‘the business’). In return, the business leases or rents it for an agreed period, making monthly payments over the equipment’s usable lifespan. The asset finance lender assumes responsibility for insuring and maintaining the equipment for the term of the agreement.

While asset finance could be an option for any business looking to buy expensive equipment, its particularly useful for businesses that can’t raise sufficient funds, or want to the spread the cost of an equipment purchase over an extended period.

…its particularly useful for businesses that can’t raise sufficient funds…

The term of most asset finance agreements is set from 1 to 7 years, or sometimes longer if the asset for purchase is of extremely high value. The period is designed to allow the financier enough time to recoup the purchase cost of the equipment and its maintenance plus interest.

Specific agreement periods are determined by the usable life of the asset, and how long the financier is willing to allow for full payment. Asset Finance companies typically make a calculation that balances the level of risk they’re willing to accept with the level of profit and interest they want to achieve.

What are the benefits of asset finance?

Every business has different needs and asset finance can offer different advantages — all of them significant.

Reduces upfront costs

Asset finance eliminates the upfront costs associated with large capital purchases as the asset finance provider will purchase the asset on the business’s behalf.

Improves cash flow

Asset finance sets in place a predictable schedule of regular payments. This allows businesses to spread the cost of the asset throughout its usable life, improving cash flow and increasing the amount of working capital available to the business. With multiple financing agreements for its equipment, a business may also agree a fixed or more favourable interest rate.

Frees up working capital

By allowing businesses to sidestep the costs of upfront purchase, asset finance frees up cash reserves to be deployed elsewhere. Businesses get the equipment they need without an initial capital commitment, making more funds available for investment in other growth activities.

Minimises the impact of depreciation

Many types of equipment can fall victim to rapid depreciation over a relatively short time frame. Some will lose a third of their value the moment you take delivery. If the equipment is on your books as an owned asset, it undermines the security of the business as you wouldn’t be able to recoup full value in a sale. There can also be a serious cost implication if the asset needs to be replaced earlier than planned.

Asset finance alleviates these risks by making the financier the asset owner. They take responsibility for any unexpected loss in value or replacing the asset if it fails to survive the duration of the agreement.

Eliminates unexpected costs

Asset finance protects businesses from any unforeseen expenditure needed to keep the asset running, or to dispose of it. The financier typically assumes responsibility for all management, maintenance, and disposal.

Provides additional credit

If a business is unable or unwilling to extend existing debt facilities like bank loans and overdrafts, an asset finance agreement lets them avoid the higher interest rates normally associated with overdraft and traditional loans.

Limits the need to provide additional security

In most asset finance arrangements, the asset itself provides enough security for the financier to approve it. It’s worth noting however that in some cases, a deposit may still be required.

What kinds of equipment assets are eligible?

To qualify for asset finance, the equipment in question will need to abide by certain basic industry criteria for durability, identifiability, movability, and (re) sale-ability – or DIMS in the language of the industry.

These criteria provide a litmus test to determine whether an asset is appropriate for financing. Financiers always look for ways to reduce their risk. In recent years however the DIMS framework and definitions of what constitutes an asset have both become more flexible.

There are now two categories of finance-able asset:

Soft Assets

Soft assets are those with little or no resale value at end of their usable life. Examples include IT hardware, office furniture, medical devices, HVAC, security and CCTV systems.

Soft Assets are much riskier to finance as they reduce the amount of security the financier could claim in the event of a default. To counter increased risk, asset finance providers often require some form of additional security, for example, a director’s guarantee, upfront deposit, or another asset that could serve as collateral.

Hard Assets

As the name suggests, hard assets are physical machines with a high resale value.  Examples include agricultural machinery, HGVs, printing presses, recycling processors, production and plant equipment, and construction vehicles.

These types of machinery tend to be revenue-producing, and as such retain significant value even at the end of their usable life. That minimises the risk for asset financiers so it’s not surprising that most asset financing is provided for hard assets.

What are the different options for asset finance?

There are three primary types of general asset finance, and others for specialised use cases.

Option 1: Hire purchase

In Hire Purchase, the business leases its equipment from an asset finance provider, who in turn agrees to purchase and provide the asset for lease. During the lease period, the provider owns the equipment, insures it and maintains it; while the business makes regular payments. At the end of the leasing period, the business owns the equipment.

A typical agreement structures payments flexibly to minimise the impact on cash flow. For accounting purposes the asset is entered on the business’s balance sheet as both a liability and an asset, with the rental cost listed as a business expense against P&L.

Option 2: Finance Lease

In a Finance Lease, the financier agrees to purchase an asset outright for the business, who in turn lease it over a fixed period and make regular payments. At the end of the agreement the financier sells the asset – but both parties benefit from the sale, usually meaning that the business gets a reduced final payment or cash back from the sale.

The business takes ownership and assumes full responsibility for the asset at the start of a lease, meaning they’re fully responsible for maintaining and insuring the asset – not the financier. Also, there is no mechanism for the business to take ownership after the leasing period is over. Unless otherwise agreed, the intention is always to sell to a third party at the agreement’s end.

Option 3: Operating Lease

Operating Leases are designed for businesses that need equipment, but not for its full working life. It’s often used when a business needs additional capacity to service a new or expanded contract.

For the leasing period, the business typically takes ownership of the asset and is responsible for maintenance and insurance. It’s not uncommon for the provider to take on some percentage of the maintenance costs.

Rental costs are calculated on the value of the asset over the agreed leasing period and not based on the full value of the asset. That reduces the overall cost to the business.

Specialised options

The following are variations on the three main types of asset finance designed to address specific types of equipment or the requirements of certain sectors:

Contract Hire

Contract Hire or vehicle asset finance agreements are used for leasing vehicles. A business will approach an asset finance company looking to attain a vehicle or add to its fleet. The asset finance company will then source the vehicle and provide maintenance and disposal when the lease period ends.

In Contract Hire the business benefits from the financier’s ability to purchase at high volume, and avoids the time and expense of finding a vehicle and maintaining it.

Refinancing

Refinance agreements are closely related to asset-based lending. A business agrees to sell an equipment asset to a financier, who in turn pays a sum back to the business and purchases the asset.

The business then leases back the equipment they have sold and make regular use payments plus interest to the financier until the lump sum has been paid off. Refinance enables asset-rich businesses to raise capital quickly with no disruption to operations.

Businesses often turn to refinancing during a negative trading period, when they need cash but can’t reduce their operating capability. It’s also seen as a viable option for businesses with poor credit or limited financial history.

Asset finance. A fast-growing market

Traditionally, asset finance has only been available to large businesses needing high-priced equipment. A growing number of independent asset financing companies however have entered the market, offering a lower threshold for the value of equipment they’re willing to finance.

With more choice and flexibility available, mid-sized businesses are looking to asset finance with greater frequency, but it isn’t for everyone.

Some providers will only work with PLCs, or expect a higher minimum financing threshold amount for companies outside their favoured categories. And asset finance does have some drawbacks.

As a vehicle for funding capital expenditures, especially in a tough economic climate, asset finance can be a cost and tax-efficient alternative.

As the business doesn’t own the assets covered under agreements there’s no ability to sell should an urgent need arise. They also can’t be seen as a short term fix. The minimum term length of agreements means they can’t be used to boost working capital quickly.

If a piece of equipment is damaged accidently, it may not be covered by the financier. Any business pursuing an asset financing contract will need to demonstrate its ability to make regular payments, and show that the payments are affordable.

As a vehicle for funding capital expenditures, especially in a tough economic climate, asset finance can be a cost and tax-efficient alternative. Do your homework and then speak to a provider about the options best suited to your business.