What Is Cash Flow Financing?
Cash flow financing is a form of financing in which 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 a lot of physical assets, such as equipment, that would typically be used as collateral for a loan.
- 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—or a cash flow loan—uses the generated cash flow as a means to pay back the loan.
- Cash flow financing helps companies that generate cash from sales but don't have a lot of assets to be used as collateral for 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 the loan. 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.