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How to understand cash flow lending

If your business needs extra cash to cover daily expenses, you may want to consider taking out a loan. After all, cash flow is the lifeblood of a healthy business, and sometimes you need a little extra help during times when cash flows are inconsistent or you’re dealing with late payments. But depending on your credit history, certain types of traditional bank loans may not be available. That’s where cash flow lending comes in... Find out more with our cash flow lending definition, as well as our explanation of asset-based lending vs. cash flow lending.

Cash flow lending definition

Cash flow lending is a type of unsecured loan that is used by businesses for day-to-day operations. Generally, the loan is used to finance working capital, such as payments for payroll, rent, inventory, and so on, and is paid back by your business’s incoming cash flows. This means that you’ll be borrowing from revenues that you’re expecting to receive in the future.

When you’re looking at cash flow lending for businesses, it’s important to remember that these loans aren’t traditional bank loans, which require a much more thorough analysis of the business’s financial health, including credit history. Instead, eligibility for cash flow lending is determined almost exclusively by your business’s capacity to generate cash flows.

How does cash flow lending work?

In most cases, cash flow lending is used by small companies that don’t have the required assets to back up a loan, a track record of profitability, or a significant credit history. This means that the lender will often charge higher interest rates, while the origination fee is also likely to be higher. It’s always important to repay cash flow loans as quickly as possible, as they can become a real drain on your business’s finances if you start missing payments.

Let’s look at a situation where cash flow lending could be an appropriate course of action. Imagine a seasonal business, such as a greetings cards company, that makes most of its annual sales from November to January. This company may experience low cash flows during the summer months, so to cover the cost of payroll and rent, they may consider taking out a cash flow loan. When cash flows kick in during the winter, they’ll repay the loan, with interest.

Limitations of cash flow lending for businesses

While cash flow loans provide the type of quick capital injection that can be vital for businesses in dire straits, it’s important to remember that there are several limitations associated with them:

  1. High fees – As well as high interest rates, cash flow loans typically have very high fees, as well as significant penalties for late payments. Before taking out a cash flow loan, it’s worth thinking about whether you have the capacity to deal with these fees if you miss one of your scheduled payments.

  2. Personal guarantees – While you don’t need assets to cover a cash flow loan, lenders may place a general lien over your entire business as part of the loan agreement. This means that your business itself will serve as collateral. In addition, you may be required to sign a personal guarantee for the loan, which would make you personally responsible for paying it back.

  3. Automatic payments – Some lenders will require automatic payments as a condition of the loan. For businesses whose cash flow varies from month to month, let alone day to day, automatic payments could mean that you don’t have enough money in your business account to make the payment.

Asset-based lending vs. cash flow lending

There are a couple of key differences between asset-based loans and cash flow loans. First and foremost, the collateral is different. Asset-based lending is backed up by assets, such as real estate, inventory, or equipment. By contrast, cash flow lending for businesses is based on expected future cash flows. Although cash flows are considered by the lender when providing an asset-based loan, it’s a secondary consideration to the value of assets on the company’s balance sheet.

It’s also worth thinking about suitability when it comes to asset-based lending vs. cash flow lending. Asset-based loans are much better suited for organisations with large balance sheets, while they may also be a good idea for companies in industries that don’t provide significant cash flow potential. Cash flow lending, however, tends to be well suited to companies with high margins on their balance sheets, as well as businesses which lack the hard assets required to back an asset-based loan.

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