Cash Flow Financing the Right Way
December 8, 2022 | Last Updated on: January 27, 2023
December 8, 2022 | Last Updated on: January 27, 2023
Are you a small business owner who needs funding for your company? Are you lacking collateral to qualify for a loan? Cash flow financing could be a solution for you.
This guide provides the information needed to decide if a cash flow loan makes sense for you and, if so, how to get the right one.
Cash flow financing is a type of small business loan. A funder makes a loan to a company backed by its projected cash flows. Businesses that practice careful cash flow management are usually approved for this type of financing.
Definition: Cash flow is the amount of cash that flows in and out of a small business during a defined period.
Cash flow financing, often referred to as a cash flow loan, leverages the future cash flow of a business as an indicator that it can pay back the loan. Cash flow loans are attractive to small businesses that generate a large amount of cash from their sales but don’t have much in the way of physical assets, such as vehicles or equipment, which would typically be used as collateral to back the loan.
If a small business has significant positive cash flow, it signals to lenders that it generates enough cash from its revenue to meet its financial obligations. Negative cash flow, usually due to low sales or high operating expenses, indicates an inability to repay the financing. Banks and other creditors carefully review a company’s cash flow to figure out how much credit to extend.
Cash flow financing can be either short-term or long-term, providing flexibility to serve many business needs. Small businesses use funds from these loans to manage financial emergencies, as working capital, to take advantage of opportunities, or make significant purchases.
Businesses that get cash flow financing are essentially borrowing against a portion of the cash they expect to generate in the future. Banks, online lenders, or other creditors provide a payment schedule based on the cash projections of the business as well as historical cash flows.
A business cash flow statement (CFS) reports operating cash flow (OCF or cash flow from operations). The statement records the net income (net operating income) for a period of time. You calculate net OCF by removing the expenditures (cash outflows) required to run the business, such as bills paid to suppliers, rent, and insurance companies, from the income generated from sales (cash inflows).
The cash flow statement for a given period also records investments in the company (such as purchasing machinery and equipment) or securities or other financial investments. A cash flow statement records financing and loan activities, such as raising money through short-term and long-term debt, taking on investors, or issuing bonds. Finally, the statement records the net amount of cash generated or lost for the period.
Be aware that cash flow from operating activities is considered by lenders. Cash flow from investing activities and cash flow from financing activities are not.
The bottom line: The more free cash flow your business has, the more financing you’ll likely qualify for.
Two factors critical to any cash flow projection are the accounts receivable and accounts payable of a company.
Definition: Accounts receivable is money owed by customers for goods and services sold by a business that could be collected in 30, 60, or 90 days.
Put simply, accounts receivables are future cash payments to a business for goods and services sold today. Banks or creditors use the anticipated receivables due to be collected to help project how much cash could be generated in the future.
Definition: Accounts payable are short-term debt obligations or liabilities, such as money owed to suppliers, utilities, and lenders.
The net cash generated from receivables and payables can be used to forecast cash flow. The amount of money expected to be generated is used by lenders to determine the loan amount.
Different lenders have their own guidelines on how much positive cash flow a business must have to be approved for a loan. They may also have minimum credit rating requirements based on the company’s outstanding debt and history of paying off its loans and other obligations. The business owner’s credit rating and the company credit rating could be checked to ensure both have a solid history of paying back debts.
Cash flow financing is significantly different from asset-backed loans. Asset-based financing helps small business owners borrow money. The loan is backed by assets owned by the business. Assets used as collateral could include equipment, inventory, machinery, land, or company vehicles.
Lenders place a lien on assets used as collateral. If the business defaults on a loan, meaning it cannot make principal and interest payments, the lien makes it easy for the lender to seize the assets legally.
Small business owners may also be required to use personal assets to back a loan or make a personal guarantee. Similar to business assets used as collateral, lenders can seize personal assets if the loan’s not paid back.
Cash flow financing works in a similar fashion in that the expected cash earnings are used as collateral for the loan instead of physical assets.
Companies that use asset-based financing have significant fixed assets, such as manufacturers, while companies that use cash flow financing are typically those that don’t have much in the way of assets, such as retail or service companies.
Follow these steps to get cash flow financing.
You’ll also likely be required to sign a personal guarantee.
If you have any questions or concerns about your agreement, ask your lender. If they refuse to clarify anything, move on to a lending company that’s more honest and straightforward.