What Is Cash Flow Financing?
Cash flow financing is a form of business financing. Under these terms, a loan made to a company is backed by a company's expected cash flows. Cash flow is the amount of cash that flows in and out of a business in a specific period.
Cash flow financing—or a cash flow loan—uses the generated cash flow as a means to pay back the loan. Cash flow financing is helpful to companies that generate significant amounts of cash from their sales but don't have the physical assets, such as machinery, that would typically be used as collateral for a loan.
Key Takeaways
- Cash flow financing is a form of financing in which a loan made to a company is backed by the company's expected cash flows.
- Cash flow financing helps companies that generate cash from sales but don't have many assets to use as collateral for a loan.
- A company's cash flow is reported on its cash flow statements, along with investing or financing activities.
- Lenders use the cash flow statement, along with the company's accounts receivable and accounts payable, to project future cash flows and set the terms of a loan.
Understanding Cash Flow Financing
If a company is generating positive cash flow, it means the company generates enough cash from revenue to meet its financial obligations. Banks and creditors analyze a company's positive cash flow as a means of determining how much credit to extend to a company. Cash flow loans can be either short term or long term.
Cash flow financing can be used by companies seeking to fund their operations or acquire another company or other major purchase. Companies are essentially borrowing from a portion of their future cash flows that they expect to generate. Banks or creditors, in turn, create a payment schedule based on the company's projected future cash flows as well as an analysis of historical cash flows.
The Cash Flow Statement
All cash flows are reported on a company's cash flow statement (CFS). The cash flow statement records the company's net income or profit for the period at the top of the statement. Operating cash flow (OCF) is calculated, which includes expenses from running the company, such as bills paid to suppliers as well as operating income generated from sales.
The cash flow statement also records any investing activities, such as investments in securities or investments in the company itself, such as purchasing equipment. And finally, the cash flow statement records any financing activities, such as raising money through lending or issuing a bond. At the bottom of the cash flow statement, the net amount of cash generated or lost for the period is recorded.
Projecting Cash Flows
Two areas that are important in any cash flow projection are a company's receivables and payables.Accounts receivables are payments owed from customers for goods and services sold. Accounts receivables might be collected in 30, 60, or 90 days in the future.
In other words, accounts receivables are future cash flows for goods and services sold today. Banks or creditors can use the anticipated amounts of receivables due to be collected to help project how much cash will be generated in the future.
A bank must also account for the accounts payables, which are short-term debt obligations, such as money owed to suppliers. The net amount of cash generated from receivables and payables can be used to forecast cash flow. The amount of cash being generated is used by banks as a way to determine the size of the loan.
Banks might have specific guidelines regarding the extent of positive cash flow needed to get approved for cash flow financing. Also, banks might have minimum credit rating requirements for a company's outstanding debt in the form of bonds. Companies that issue bonds are assigned credit ratings as a way to assess the level of risk associated with investing in the company's bonds.
Cash Flow Loan vs. Asset-backed Loan
Cash flow financing is different from an asset-backed loan. Asset-based financing helps companies to borrow money, but the collateral for the loan is an asset on the balance sheet. Assets that are used as collateral might include equipment, inventory, machinery, land, or company vehicles.
The bank puts a lien on the assets that are used for collateral. If the company defaults on the loan—which means they don't pay back the principal and interest payments—the lien allows the bank to legally seize the assets.
Cash flow financing works in a similar fashion in that the cash being generated is used as collateral for the loan. However, cash flow financing doesn't use fixed assets or physical assets.
Companies that typically use asset-based financing are companies with a lot of fixed assets, such as manufacturers, while companies that use cash flow financing are typically companies that don't have a lot of assets, such as service companies.
What Are the 3 Types of Cash Flows?
Cash flow can come from three sources: operating activities (generally sales), investments, or financing (loans or lines of credit). All three types should be reported on a company's cash flow statement.
Are Cash Flow and Profit the Same Thing?
Cash flow shows the money that moves in an out of your business through sales, investments, financing, debts, and bills. It is reported on the cash flow statement. Profit, on the other hand, shows how much money if left over after all your business expenses have been paid. It should be reported on your company's income statement.
What Is the Benefit of Cash Flow Financing?
Cash flow financing is beneficial to company's that generate a lot of revenue but don't have many physical assets. Since the business uses future cash flow to back the loan, it can get financing even without using an asset as collateral.
The Bottom Line
Cash flow financing is a kind of business loan. A company will commit to using future cash flows as a means to pay back a loan. Lenders use the information on a company's cash flow statement, along with information about a company's accounts payable and accounts receivable, to project future cash flows. This allows the lender to determine the size of the loan they will offer.
Many business loans are asset-backed loans, in which a lien is placed on physical assets such as machinery or vehicles as collateral for the loan. Cash flow financing, on the other hand, is useful for companies that generate a lot of revenue but don't have many physical assets.
