If you own or manage a small business, you know that running a successful business is tough. It can be even harder if you don’t have access to finance. That’s why cash flow loans are so important. They allow businesses to cover short-term expenses while they wait for long-term funding to come in. And since cash flow loans are often for a short time, there should not be tough preconditions of having the perfect credit score or being a low-risk borrower.
The Problem of Running Finance
Small businesses often have difficulty meeting their financial obligations in the fall and winter months, when demand for their products or services is low. This is because these businesses typically rely on cash flow from their operations to cover expenses like salaries, rent, and marketing campaigns.
However, if a small business doesn’t have enough cash flow to cover its costs during these times, it may be forced to borrow money from a lender in order to continue operating. These loans can come with very high-interest rates, which can really put a dent in a small business’ finances. Banks rarely care about small businesses. They hardly lend money without collateral. But the small firms often lack the assets or capacity to meet banks’ plethora of technical requirements. This hinders small business growth and ultimately economic growth.
So why do small businesses need cash flow loans? The answer is two-fold. First, these loans provide necessary short-term relief for small businesses during tough times. Second, they help build up a business credit score and lead to more favorable lending conditions in the future.
Cash Flow Financing
What is cash flow financing? It is a way for a business to get a loan from the bank to cover its short-term financial needs. But this loan is guaranteed by the expected cash flow from future sales rather than the physical or fixed assets of the business. The cash flow of any business is the amount of money coming in and going out of the business in a given period. In the case of a cash flow loan, the positive cash flow generated over a specified period of time is used for loan repayment.
Positive Cash Flow and Debt
If a business generates a positive cash flow, it means that it is providing enough cash from its income to meet its financial obligations. Banks or other lenders check positive cash flows to determine how much and how long they can issue loans. Given the expected positive cash flow, loans can be obtained not only for the short but also for the long term. This is because it may sometimes take more than a year for a business to make positive cash flows.
Often, a business firm can use this source of financing if it needs funds to continue its routine operations. However, cash flow loans for businesses can also be used to buy another business or fund a large purchase. The loan amount can be obtained as part of the expected positive cash flow in the future. The bank or lenders can review the expected future cash flow estimates submitted by the applicant business and schedule the loan issuance and its repayment. Of course, this needs to be double-checked with the business’s past or some other criteria the lender may find important.
Need for Cash Flow Loan?
Any business, big or small, may experience a temporary reduction in cash flow. This can happen for a number of reasons, such as:
- Seasonal changes may reduce cash sales and increase the credit period.
- A business can incur unexpected costs in the event of a loss or economic distress.
- Starting an expensive new project or making a big purchase can also create a cash-flow gap.
- Taking advantage of a particular opportunity in time can also affect temporary cash flow, such as benefiting from buying goods at a higher discount.
- Emergency repairs to essential equipment or machinery may also be required.
There are a number of other reasons why cash flow loans for businesses could be required due to the difficulty in their cash position. But most often, small business cash flow loans are used to fulfill short-term gaps. Banks need to be responsive to offer temporary support, especially to small businesses.
Cash Flow Estimate
How do you prepare a statement of cash flow? A document called a cash flow statement is prepared to show the cash in and outs of any business. This document reports the cash flows generated as a result of all business activities and represents the net income or cash position of any business. The business activities for the purpose of preparing the cash flow statement are divided into three parts.
- Daily tasks are called operating activities. The resulting cash flow of such activities is called operating cash flow. These include supplier bills that are paid by the business and also include operating income from sales (cash and credit sales recoveries).
- Some activities are investing activities. Under them, the investment made by the business in another place or the investment coming into the business itself is calculated.
- The third type is called financing activities. Such as raising funding through loans or providing capital by the owners etc.
The positive or negative cash flow in a business is derived from the accumulation of cash flow from all three types of activities. In order to apply for a cash flow-based loan, it is necessary to review all these expected activities for the future period under review so that the cash flow can be accurately estimated. Banks use the same estimate to determine the size of the loan and repayment schedule.
To estimate how much cash will be generated in the future, the Bank specifically considers receivables of credit sales accounts and payables of credit purchase accounts. The bank can also review the applicant’s credit history or credit rating to accurately estimate the risk associated with cash flow loans for small entrepreneurs.
Benefits of Cash Flow Loan
A loan based on a guarantee of physical assets is safe for the bank, but it becomes a huge risk for the business. The bank has the right to legally seize the assets in case of default. This can cause a business to lose complete control over its assets and its ability to operate.
On the other hand, even for a bank, exercising complete control over pledged physical assets is not an easy task. In case of default, the bank has to go through significant legal complications to recover the loan by selling the pledged assets. In some cases, the market value of assets significantly drops until the point of sale or auction.
With cash flow-based financing, borrowing and lending become easy for both parties. Cash flow loans are a solution to financing problems of small businesses because they do not own many physical assets to offer as collateral. We can take the examples of today’s service or technology-related businesses. They do not own many physical assets but their current or projected sales can be quite impressive.
Therefore, both lenders and borrowers can significantly increase their revenue by using the cash flow financing method. If banks are unwilling to be flexible in their policies in this regard, their portfolio of outstanding loans may reduce significantly in the future. Because there is an upward trend in investments in digital or intangible assets rather than physical assets with the introduction of decentralized finance (DeFi).
The cash flow loan for business allows entrepreneurs to obtain a loan by offering future cash flows as security. Most businesses have short-term needs for which such loans can be used. They can be saved from closing due to a failure to meet short-term financial needs. Cash flow-based lending is helpful, particularly for smaller firms, the service, and IT sectors, and the cottage industry to thrive.
What are your views about cash flow loans for small businesses in order to fulfill their short-term financing needs? How do you think banking systems should respond to the needs of small businesses? Please share valuable input in the comment section below for the benefit of our readers.