What is cash flow financing? With cash flow financing, a company gets a loan, but that loan is backed by the company’s expected cash flows. A company’s cash flow is the amount of money flowing from and to a business, in a specific period. Cash flow financing, or a cash flow loan, uses generated cash flow to pay the loan back.
If a company generates positive cash flow, this means it is bringing in enough cash from revenue to meet financial obligations. Banks and credit providers check positive cash flow to determine how much credit they want to extend.
You can get cash flow loans for either short- or long-term. Companies can use this means of financing if they’re looking to fund operations, to buy another business, or for other major purchases.
The idea is that companies borrow from a fraction of the future cash flows they expect to make. Banks or creditors put together a payment schedule. They base this schedule on predicted future cash flows and analyzing historical cash flows.
Why seek cash flow financing?
A business may have a temporary decrease in cash flow. This could come from less than stellar seasonal sales. A company might be facing unexpected expenses. Starting a costly new project could create a gap in cash flow.
A decrease in cash flow can also come from taking advantage of a limited-time opportunity, like buying equipment at a steep discount. Or businesses can suffer from cash flow decreases when they need to make emergency repairs to vital equipment.
Cash flow statements
All cash flows get reported on what is called a company’s cash flow statement, or CFS. This statement records a business’s net income or profit, for the time period covered in the statement. The statement calculates operating cash flow from expenses arising from running the company. These include supplier bills paid by the business. It also includes operating income coming from sales. The statement also records any investing activities.
Investing activities include investments in securities or in the company itself, like buying equipment. The statement records any financing activities, like raising capital via lending or even issuing a bond. The bottom of the cash flow statement shows the net amount of cash generated or lost for the time period.
Cash flow projections
Two vital areas in any cash flow projection will be a business’s payables and receivables. A bank must consider accounts payables. These are short-term debt obligations, like money owed to suppliers. The bank can use net cash from payables and receivables to forecast cash flow. Banks use this amount to determine the size of the loan.
The bank will also need to consider accounts receivables. Accounts receivables serve as future incoming cash flow for goods and services a business sells today. Banks or credit providers will use the anticipated amounts of receivables due for collection to help figure out how much cash will be generated in the future.
Banks may require a minimal credit rating for a company’s outstanding debt in the form of bonds. Companies issuing bonds are assigned credit ratings. This is how the level of risk associated with investing in the company’s bonds is weighed.
Cash flow loans versus asset-backed loans
Asset-based financing works to help companies borrow money. However, an asset on the balance sheet serves as the collateral for the loan. The bank puts a lien on any assets used for collateral. Assets used as collateral can include inventory, machinery, real estate, company vehicles, etc.
If the company ends up defaulting on an asset-backed loan, the bank lien allows for the lender to legally seize the assets. Hence a business can lose its ability to function.
With cash flow financing, the generated cash is used as collateral for the loan. Collateral does not come in the form of physical or fixed assets. Typical businesses using cash flow financing often don’t have very many assets, like service companies.
Cash flow loans strike a balance between loan size, APR, and length of application process. Contrast that with many unsecured online loans, which can have very fast approval, but a limit on loan amount. In addition, they tend to charge a very expensive APR.
Cash flow financing can also be an improvement over traditional financing. Traditional banks offer larger loans, often over one million dollars, and a lower APR, but it can take months to fund an account.
Often, a company must be in operation for a few years. The borrower may need to meet a certain minimum credit score requirement. They also must prove historical cash flow, and present accounts receivables and accounts payables, so the lender can determine the amount to be made available.
Cash flow financing lets entrepreneurs borrow against future cash flow. It’s generally used for temporary needs, like buying equipment quickly, or starting a new project. It can be a good solution for service industries with little traditional collateral.
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Original source: Entrepreneur