Understanding cash flow finance and its advantages
What is cash flow financing?
Cash flow financing is borrowing money based on your projected cash flow. You essentially borrow a portion of the cash you expect to generate in the future. Cash flow loans can be either short or long-term.
How does cash flow financing work?
When you borrow a cash flow loan, you use the cash flow generated by your business to pay it back. The lender will look at your projected sales, accounts receivable and past performance to determine how much you can borrow.
What types of cash flow require finance?
Cash flow refers to the money moving through your business during a specific time. You'll have either a positive or negative cash flow depending on whether your company makes more than it spends.
There are three types of cash flow that lenders will look at if you're considering cash flow finance: operating, investing and financing.
Operating activities
Operating cash flow is the cash generated or used by your company's core operating activities, including:
Sale of goods or services
Purchase of inventory
Utility bills
Investing activities
Investing cash flow is how much money your business has made or used through investment activities, including:
Purchasing assets
Mergers with or acquisitions of other businesses
Investments in stocks or bonds
Taking out or paying back loans
Financing activities
Financing cash flow is the amount of funding that flows in and out of your business, including:
Money borrowed from external lenders
Dividends paid to investors
Repurchase of equity, like shares that were previously issued and traded
Projecting cash flow
A cash flow projection estimates the money moving in and out of your business, including all your income and expenses. When you apply for cash flow financing, lenders will look at your accounts receivable and payable to forecast the amount of cash your business will generate. This projection will influence how much you can borrow.
When estimating operating cash flow, you need to look at your accounts receivables and payables.
Accounts receivable — money that your customers owe you for goods and services
Accounts payable — money that you owe, for example, to suppliers
What are the advantages of cash flow finance?
Cash flow finance has several advantages, particularly if your business doesn't have fixed or tangible assets to use as collateral for other, more traditional financing options.
It's a way to access cash — fast
You may need to cover an unexpected cost, plug a cash flow gap caused by late-paying customers, or cover payments to suppliers due to a spike in demand.
It can help plug cash flow gaps
If you run a seasonal business, your cash flow is likely more sporadic than a business with steady sales throughout the year. Therefore, you could experience cash flow gaps during the low season.
It can help grow your business
Cash flow financing can help fund a growth project without eating into cash set aside for operating costs. It can also cover bulk purchase payments so you can negotiate better deals with suppliers.
What are the disadvantages of cash flow finance?
There are also some disadvantages of cash flow finance that you should consider before signing any agreement:
Higher fees
Cash flow financing is riskier for the lender, and therefore comes with above-average interest rates, higher fees and significant charges for missed or late payments.
Personal guarantees
While cash flow financing is unsecured, that doesn't mean the lender can't make a claim if you default. Lenders may place a general lien on a business, meaning your entire operation will serve as collateral. Further, as the business owner you may be personally liable for repaying the debt.
Automatic payments
Most lenders require businesses to set up regular automatic payments to repay a cash flow loan. If you don’t have funds in the allocated account, you'll miss a payment and may be charged a late fee. You'll need to be diligent about ensuring you've the funds to cover each repayment, especially if your cash flow fluctuates weekly or monthly.
Cash flow finance vs traditional business loans
The difference between cash flow financing and traditional business loans is what security lenders require.
Traditional business loans
These loans are often asset-based, meaning lenders will secure the loan against an asset on the balance sheet as collateral. Assets can include land, work vehicles, commercial property, equipment or inventory. If you default on the loan, your lender can legally seize the asset to recover the money you owe. Typically, this financing option is suited to larger businesses with more assets.
Cash flow financing
Cash flow loans don't require fixed or tangible assets as security. Instead, projected cash flow determines the lending, which can work well for smaller businesses with higher margins or fewer assets.
Cash flow finance FAQs
Are cash flow loans unsecured?
Cash flow loans are unsecured, meaning lenders don't require tangible assets like property or equipment as collateral.
What's an example of cash flow risk?
A cash flow risk refers to the possibility of falling short on cash because of your cash flow management practices.
These are some typical cash flow risk examples:
An economic downturn and its knock-on effects
Increase in interest rates
Decrease in sales
Slow-paying customers
Is cash flow the same as profit?
Cash flow is shown on your cash flow statement as money moving in and out of your business. Profit is shown on your income statement as the money you've after you've paid all your business expenses.
How do you prepare a cash flow statement?
A cash flow statement details your company's cash assets during a specified period, and includes a breakdown of where the business has made and spent its money.
There are typically nine steps to preparing a cash flow statement:
Gather financial documents and data.
Identify your opening cash balance.
List incoming cash.
Calculate your total incoming cash amount.
List outgoing cash.
Calculate your total outgoing cash amount.
Adjust for non-cash items.
Calculate cash flow.
Calculate your closing cash balance.
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Disclaimer: Information provided in this article is of a general nature and does not consider your personal situation. It does not constitute legal, financial, or other professional advice and should not be relied upon as a statement of law, policy or advice. You should consider whether this information is appropriate to your needs and, if necessary, seek independent advice. This information is only accurate at the time of publication. Although every effort has been made to verify the accuracy of the information contained on this webpage, MYOB disclaims, to the extent permitted by law, all liability for the information contained on this webpage or any loss or damage suffered by any person directly or indirectly through relying on this information.