Last Updated on October 27, 2023 by Gerry Stewart
Cash flow based financing is a type of business funding that assesses a company’s cash flow, rather than traditional credit metrics, to determine eligibility. It provides businesses with working capital by leveraging their cash flow history, making it particularly valuable for companies with seasonal revenue fluctuations or those seeking flexibility in their financial options. This financing method helps businesses address short-term cash needs and maintain their operations efficiently.
Begin this article because it holds the blueprint for optimizing your cash flow and achieving financial success.
In this guide, we will explore the ins and outs of cash flow based financing to help businesses and investors make informed decisions.
Key Takeaways Include:
- Cash flow loans use a company’s expected future cash flows for underwriting rather than physical collateral. This expands access to capital for newer and innovative firms.
- Major benefits are speed, flexibility, preserving ownership, and matching repayment to revenue cycles. Downsides include higher costs and overdependence on projections.
- Cash flow analysis and forecasting are vital skills for securing affordable financing and optimizing working capital.
What is Cash Flow Based Financing?
Cash flow based financing refers to loans and financing options that use a company’s expected future cash flows as the primary basis for making lending decisions, rather than tangible assets like property, equipment or inventory.
With cash flow based financing, lenders analyze a business’s financial history and projections to estimate its ability to generate adequate cash flow for loan repayment in the future. The key factors assessed include:
- Revenue and sales trends – Current and historical revenue figures indicate the size and growth of the business. Higher and accelerating revenue suggests the greater ability to service debt.
- Profit margins – Net income and gross margin percentages demonstrate profitability. Wider margins mean more cash available after expenses to repay creditors.
- Cash flow stability – Fluctuations in cash flow impact the reliability of meeting loan obligations. Steady cash inflows reduce default risk.
- Debt service coverage ratio (DSCR) – This measures whether cash flow is sufficient to cover current debt payments. Higher ratios above 1.0x indicate greater capacity to take on additional debt.
- Credit score and history – Past payment performance and creditworthiness determine eligibility. Many cash flow lenders have minimum score requirements.
The major types of cash flow based business financing include:
- Revenue-based financing – Repayment is a fixed percentage of monthly or weekly revenue. This aligns with seasonal business cash flows.
- Profit-share loans – Lenders receive a percentage of net income or gross profits as repayment, up to a capped amount.
- Royalty financing – Repayment is based on a percentage of sales revenue, similar to royalty payments.
- EBITDA loans – Interest and principal payments are tied to a multiple of earnings before interest, taxes, depreciation, and amortization (EBITDA).
- Purchase order financing – Repayment comes from customer payments on outstanding invoices or purchase orders.
- Inventory financing – The loan is repaid from sales of the inventory purchased with the loan proceeds.
- Invoice factoring – The lender purchases accounts receivable at a discount and provides funds against the value of the invoices.
Compared to traditional bank loans, cash flow based financing offers greater flexibility, higher approval rates, faster funding, and no collateral requirements. The tradeoffs are higher costs and stricter repayment terms tied directly to cash flows.
For many startups and growth companies, the speed and convenience outweigh the higher rates. Cash flow loans allow them to access growth capital without diluting ownership via equity financing.
Why Choose Cash Flow Based Financing?
Cash flow based financing offers several unique benefits that make it an attractive option for many small and medium businesses (SMBs), especially those with strong growth prospects but limited assets to put up as collateral.
1. Access to Fast, Flexible Funding
By looking at expected future cash flows rather than tangible assets, cash flow lenders can approve loans much faster and with fewer requirements than banks. This enables businesses to seize opportunities at critical junctures.
Approval is also based more on the fundamentals of the business rather than just its credit rating or assets. This gives newer businesses with shorter credit histories access to financing that might be denied by banks.
2. Preserves Ownership and Control
Cash flow loans do not require giving up any equity in the business. The founders maintain full ownership and control rather than diluting it by raising equity financing from VCs and angels.
This also enables businesses to avoid restrictive covenants that often come with VC funding. They retain flexibility in operating the business.
3. Matches Repayment to Revenue Cycles
Aligning repayment with cash receipts from ongoing business operations is beneficial for companies with fluctuating incomes. This includes seasonal businesses, project-based firms, and those with longer sales cycles.
Options like revenue-share loans automatically adjust the repayment amounts based on that month’s sales. This prevents defaults from revenue volatility.
4. Requires No Collateral
Cash flow lenders do not require fixed business assets like property, inventory, or machinery to be pledged as collateral. This enables asset-light firms like technology startups to access loans.
Inventory and equipment financing still use assets, but cash flow is the primary repayment source. This gives financing options to a wider range of businesses.
5. Availability of Lower Amounts
Many cash flow financing platforms provide loans from 5,000 to 500,000. This fills a major gap between credit cards (under 25k) and bank term loans (over 300k).
SMBs can access appropriately sized financing for smaller capital needs. The fixed costs of smaller loans also encourage lenders to provide financing to lower-revenue businesses.
This flexibility and convenience has made cash flow based financing popular with everyone from one-person startups to companies with several million in revenue. For growing companies, it bridges the gap between early-stage debt and eventual bank financing.
What are the Challenges of Cash Flow Based Financing?
While cash flow lending has many upsides, business owners should also carefully consider the potential downsides before committing. Some of the main challenges include:
1. Higher Interest Rates and Fees
Cash flow loans typically have annual interest rates from 7% to 30%, compared to 4% to 8% for bank term loans. The exact rate depends on eligibility criteria. There may also be origination fees of 1% to 10% deducted from disbursements.
The higher pricing is associated with the increased risk and accelerated underwriting process. Less stringent requirements also mean higher defaults.
2. Strict Repayment Terms with Penalties
To offset risk, cash flow lenders impose strict repayment terms tied directly to cash receipts, with weekly or daily payments in some cases. There are also often prepayment penalties for early repayment.
Missing payments can trigger expensive late fees and default interest rates exceeding 30%. Overall terms range from 3 months to 3 years with shorter durations prevalent.
3. Potentially Illegal Lending Practices
While most cash flow lenders are ethical, small businesses should watch out for predatory terms and illegal practices from certain unscrupulous providers.
Excessively high-interest rates, misrepresented terms, unauthorized withdrawals, and threats over late payments are some warning signs of predatory lending.
4. Overdependence on Uncertain Cash Flows
Basing loans on expected future cash flows carries inherent uncertainty and volatility risks. Projections might not match actual results, making repayment difficult. This uncertainty is amplified for newer businesses with limited financial history.
Careful cash flow planning and forecasting are essential to ensure adequate buffers and flexibility. Businesses need to balance pursuing opportunities with fiscal prudence.
How to Qualify for Cash Flow Based Financing?
Cash flow lenders have certain eligibility criteria that businesses must meet to qualify for financing approval. While less stringent than banks, some key requirements are:
- Time in business – Most require at least 6-12 months of operations before considering a loan. More established businesses have an advantage.
- Personal credit score – A minimum score ranging from 600 to 650 is typically required. 700+ scores improve the likelihood of funding.
- Business credit rating – Lenders review personal and business credit reports from bureaus like Equifax. Positive ratings improve changes.
- Annual revenue – Minimums range from 50k to 5 million based on deal size. Higher revenue improves access to capital.
- Gross margin % – Profitability margins of at least 10% indicate adequate cash flow to service debt.
- Debt service coverage ratio – A DSCR of at least 1.0x or 1.15x demonstrates the capacity to manage additional debt.
Beyond eligibility, having a solid business plan and financial history is vital for securing approval and attractive terms from lenders. Gerry advises:
Providing lenders with a clear picture of your business model, growth roadmap, competitive strategy, and well-supported financial projections goes a long way in building confidence and securing funding.
Documentation should highlight the factors driving growth, margin expansion, and rising cash flows that support debt repayment. Being organized and thorough demonstrates good financial management.
How to Find the Best Cash Flow Lenders
The cash flow financing landscape has expanded rapidly beyond traditional banks and now includes a wide range of online lenders, peer-to-peer platforms, fintech companies, and alternative finance providers.
Choosing the right lender involves research and comparison of factors like:
Lending Criteria – What are the minimum requirements for revenue, time in business, DSCR, and credit score?
Interest Rates – What is the APR for a 6- or 12-month loan with 70% or 80% advance rate? Any origination/closing fees?
Loan Amounts – What is the minimum and maximum financing offered? Does it match your capital needs?
Repayment Options – Are flexible options like revenue-share or interest-only payments available? Any prepayment penalties?
Funding Speed – How fast is the application review and funding disbursement process?
Customer Support – Is there an account manager available or just automated bots? How responsive is support?
Reputation & Reviews – What do customers say about the lender’s rates, terms, and service quality? Any red flags?
Online marketplaces like ROK Financial allow you to easily compare multiple lenders using filters like industry, experience, funding time, and loan amount. This makes it simpler to find the best fit.
Talking to fellow business owners who have used cash flow financing can also provide helpful recommendations. An experienced loan broker like Gerry can guide you through the most suitable options.
How to Manage Cash Flow to Support Financing
Since cash flow loans are repaid directly from business revenues, careful cash flow planning and monitoring are vital for meeting obligations and ensuring sufficient working capital.
- Create detailed projections – Build comprehensive forecast models considering seasonal patterns, revenue cycles, growth plans, and changes in margin or costs.
- Monitor closely – Track cash inflows and outflows continuously, not just monthly. Compare to projections and adjust quickly as needed.
- Optimize collections – Accelerate collecting accounts receivable. Offer payment plans and discounts for early payment.
- Extend payables – Prioritize paying the highest-interest debt first. Negotiate longer payment terms with vendors and suppliers when possible.
- Build reserves – Maintain a cash buffer for contingencies and shortfalls. 15-30% of projected outflows is recommended.
- Plan repayment – Know exactly when loan payments are due. Automate transfers to avoid missing payments.
Ongoing cash flow analysis using key metrics like cash ratio, cash conversion cycle, and operating cash flow ratio is imperative. Using cloud accounting software and cash flow forecasting tools can provide greater visibility.
|Traditional Bank Loans||Cash Flow Loans||Factoring/Invoice Discounting|
|Based on assets and credit, not cash flow||Based primarily on expected future cash flows||Based on the value of outstanding invoices|
|Collateral usually required||No collateral required||Invoice receivables are collateral|
|Lower risk profile||Higher risk due to cash flow uncertainty||Lower risk as can verify invoice amounts|
|4% – 8% interest rates||8% – 30% interest rates||Discount fees of 2% – 5%|
|Require strong credit history||Greater focus on business fundamentals||Credit history less important|
|Slower application and funding||Rapid underwriting and funding||Very fast funding after invoice verification|
|Loan terms from 1 – 5 years||Shorter terms of 6 – 18 months||Very short term until invoices are paid|
|Loan amounts $100k+||Lower minimums, often $25k+||No minimum invoice amount|
|Funds use restricted||Flexible use of proceeds||Funds restricted to operational expenses|
This table compares some of the key attributes of traditional bank loans versus cash flow loans and invoice factoring. It highlights how cash flow lending fills gaps for smaller and newer businesses with greater speed and flexibility.
Factoring provides even faster short-term financing based directly on receivables.
Questions for Lenders
When exploring cash flow financing options, asking lenders the right questions is key to finding the best fit:
- What are your minimum eligibility requirements?
- What credit score and history do borrowers need?
- How long does your application review and funding process take?
- What loan amounts do you offer for businesses at my stage?
- Do you provide flexible repayment terms like revenue sharing?
- What APRs and fees should I expect at various advance rates?
- What is the process for early repayment if I am able to?
- What customer support do you provide during the loan term?
- Can you share some case studies of clients like my business?
- What protections do I have against predatory lending practices?
Thoroughly vetting lenders helps avoid unpleasant surprises or unfavorable loan terms down the road. If possible, speaking with current clients provides helpful insight into their practices.
Cash Flow Analysis for Better Financing Outcomes
Analyzing historical cash flow is vital for securing affordable future financing and maximizing the ROI of borrowed capital. Here are some key ways it helps:
- Demonstrates creditworthiness – Consistent cash generation provides tangible proof of the ability to service additional debt.
- Allows accurate projections – Historical cash flow ratios provide a baseline for realistic forecasts of future cash flow.
- Pinpoints working capital issues – Identifying delays in customer collections or vendor payments helps improve cash cycles.
- Gauges business health – Sustained negative cash flow could indicate unprofitability or poor financial management.
- Determines financing capacity – The level of excess cash indicates how much additional debt can feasibly be serviced.
- Shows impact of investments – Change in cash flow reveals how capital expenditures ultimately affect financial performance.
- Highlights seasonal patterns – Analyzing fluctuations allows matching of repayment to revenue cycles.
Regular cash flow analysis using both the direct and indirect methods ensures you have a firm handle on historical cash generation. This provides the baseline data needed to convincingly demonstrate creditworthiness.
Direct vs. Indirect Cash Flow Methods
When analyzing cash flow from operations, companies can use either the direct or indirect method. Each has its own pros and cons:
The direct method sums up actual cash inflows and outflows from revenues, expenses, taxes, and investments for the reporting period:
- Cash Inflows
- Cash sales
- Collection of receivables
- Interest income
- Tax refunds
- Cash Outflows
- Cash purchases
- Operating expenses
- Interest payments
- Tax payments
- Easier to understand for non-accountants
- Shows actual cash transactions
- Better highlights real liquidity issues
- More difficult and time-consuming
- Requires detailed cash accounting
The indirect method starts with net income on the income statement and then adjusts for non-cash items and changes in working capital:
- Net income
- Changes in accounts receivable
- Increases in inventory
- Decreases in accounts payable
- Cash flow from operations
- Easier to calculate from the income statement
- More commonly used method
- Obscures actual cash activities
- Does not show real cash inflows/outflows
While the indirect method is more widely used for its simplicity, the direct cash flow method provides much clearer insight into real cash generation. This can reveal liquidity issues not apparent from net income alone.
Cash Flow Forecasting Tips
For businesses considering cash flow financing, producing realistic projections of future cash flow is critical for securing approval. Here are some tips:
- Start with historical data – Develop assumptions and growth estimates from revenue and cash flow trends.
- Account for seasonality – Factor in higher/lower cash periods and smoothing options like credit lines.
- Include contingencies – Buffer projections by 10-15% to allow for unforeseen events.
- Project working capital needs – Estimate future changes in receivables, inventory, and payables.
- Breakdown calculations – Show details supporting each major projection assumption. Defend estimates.
- Conduct scenario analysis – Model worst/best/likely case projections based on different assumptions.
- Link to business plan – Connect projections to key business initiatives like new products or markets.
- Update regularly – Review projections monthly as actual data comes in and quickly adjust as needed.
With strong processes and controls around cash flow forecasting, businesses can convincingly demonstrate their ability to service additional debt.
Facts and Stats About Cash Flow Lending
- According to the Small Business Credit Survey by the Federal Reserve Banks, 31% of small firms seeking financing applied for a cash flow loan in 2021.
- The most common uses of cash flow loans are expanding an existing business (40%) and starting a new business (31%), according to Michigan Economic Development.
- A recent First Analysis study found that 75% of alternative SME lenders use cash flow analysis as a central underwriting factor.
- Fintech cash flow lending platforms grew total originations by 17% yearly between 2019 and 2021 according to Annual Reviews data.
- The rise of cash flow lending has improved financial inclusion. 38% of cash flow borrowers are women-owned firms compared to 20% from banks according to Fed Communities.
The data highlights the growing demand for fast, flexible cash flow financing options that align with the needs of today’s small businesses.
Case Study 1: Coffee Shop Expansion
A successful coffee shop in Portland with strong growth in revenue and profits over its first 2 years. The owner Mary is now looking to open a second location to continue expansion.
However, as a newer business, the company does not have the real estate assets or long operational history needed to secure a sizeable term loan from a traditional bank. The new shop requires $200k in start-up costs for building lease, equipment purchases, and operating expenses until revenue ramps up.
By analyzing the last 2 years of financial data, Mary forecasts that the average new customer value is 3,200 per year. She expects the new coffee shop to bring in 450 new customers per month, leading to over 1.7 million in added annual revenue by year 3.
Based on these projections, Mary is approved for a 2-year, $200k cash flow loan from an online small business lender. The term is set up to match the expected customer ramp-up period, with interest-only payments for the first 6 months followed by 2 years of full principal and interest payments as revenues increase.
The cash flow loan provides this company with the capital needed to open its second location without diluting ownership via giving up equity. By year 4, the added shop will generate significant profit that covers the financing costs while fueling further expansion plans.
Case Study 2: Specialty Bakery Cash Crunch
Carlos owns a specialty bakery supplying custom cakes and artisanal breads to restaurants and cafes in Houston. While the bakery has strong repeat business, Carlos has faced persistent cash shortfalls.
Looking at the historical cash flow statements, Carlos notices wild fluctuations in cash from month to month, ranging from 5k to 30k. Upon further analysis, he sees this is driven by delays in receiving payments from his wholesale clients that regularly pay 30-60 days in arrears.
At the same time, Carlos has major upfront weekly costs for raw ingredients and payroll to meet orders. Attempts to negotiate shorter payment terms have been unsuccessful to date.
To smooth out this timing mismatch and provide working capital, Carlos secures a 6-month, $50k cash flow loan that quantizes payments by taking 5% of weekly receivables. As customer payments come in each week, 5% automatically goes to repay the loan principal and interest.
This aligned repayment structure provides Carlos with the constant liquidity needed to cover urgent costs. By the end of the 6-month term, the cash flow loan is fully repaid. Moving forward, Carlos plans to use this strategy to align financing with his customer payment cycles.
How to Prepare for Cash Flow Based Financing
Before applying for cash flow based financing, it is essential to have a clear business strategy and plan. This will help you determine how much funding you need, how you will use it, and what outcomes you expect. Having a solid plan will also increase your chances of getting approved by lenders who want to see that you have a viable business model and growth potential.
Some questions to ask yourself before applying are:
- What are your short-term and long-term goals for your business?
- How will you use the funds to achieve those goals?
- How will you measure your progress and success?
- What are the risks and challenges that you might face?
- How will you overcome them or mitigate them?
- What is your backup plan in case things do not go as planned?
Having a clear plan will also help you manage your cash flow more effectively once you receive the funding. You will be able to allocate your funds wisely, monitor your cash inflows and outflows closely, optimize your collections and payables, build reserves, plan repayment, and conduct cash flow analysis using key metrics and methods.
Cash flow based financing has grown popular because it aligns lending decisions with the operational realities of today’s businesses. By tapping into future cash flow potential, it provides critical access to capital for growth and expansion.
For the right businesses at the right stage, cash flow financing can provide key growth capital at critical junctures. With proper planning and structuring, the benefits often outweigh the costs. But thorough due diligence is essential.
What has been your experience with cash flow loans? Feel free to share your thoughts and questions below!
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