What is a cash flow loan?
Cash flow loans, sometimes known as working capital loans, can be used to finance growth projects, such as investing in a marketing campaign, product research or hiring salespeople. They can also help businesses tide over cash shortfalls when they’ve maxed out their line of credit due to unexpected challenges related to growth.
“A cash flow loan is a useful financing tool for many entrepreneurs,” says Catherine Vanderzwan, a BDC Senior Account Manager in Ottawa. “It can help protect working capital, especially for quickly growing companies with large cash outlays or limited assets to offer as loan collateral.”
Vanderzwan explains what entrepreneurs need to know about cash flow loans and how they can help your business.
1. How cash flow loans are different
A cash flow loan is a term loan that doesn’t require any business or personal assets to be given as collateral. Instead, bankers usually grant the loan based primarily on past and forecasted cash flow.
Cash flow loans are usually amortized for a relatively short duration, ranging from four to eight years.
A good rule of thumb is to match financing duration with the lifespan of the project or asset. “I always tell businesses to closely map the inflows and outflows of the company’s revenues and expenses,” Vanderzwan says. “It’s a good business strategy and helps you understand how money moves through your business.”
Repayment terms can vary, but may include an initial principal postponement, payments tied to cash flow and other flexible terms.
2. When is it useful
Business owners often make the mistake of paying for growth initiatives with working capital, only to wind up with a cash flow crunch. “You shouldn’t bury your cash in capital assets or other major investments, when you don’t have a buffer to fall back on,” Vanderzwan says. “This can lead to major cash flow problems that can be avoided if the business uses financing instead. It’s a common pitfall for many entrepreneurs.”
A cash flow loan may be useful if:
- your business has a history of positive cash flow but now you’re near the limit of your credit line
- you’re growing rapidly or developing a new product, but it’ll take time for sales growth to recoup the cost of investments in marketing, new hires or R&D
- you want to take advantage of supplier volume discounts without straining cash flow
- you need to buy inventory to meet a sudden spike in demand
- your top customers are taking a bit longer to pay their invoices
3. What do you need to qualify
Lenders typically look at the health of your cash flow to gauge if your business qualifies for a cash flow loan and set financing terms.
Since no collateral is being provided, the bank focuses on the quality of your accounts receivable, accounts payable and inventory turnover to see how you are managing your cash flow. Bankers like to see customers who are of good quality and pay as per their terms, suppliers being paid on time (though not too early) and rapidly moving inventory items.
In addition to historic and projected cash flow, bankers also typically check other information such as, EBITDA, sales forecasts, financial statements, the company’s management team and the owner’s personal credit score and net worth.
“We’re lending on the cash flow so we really need to understand the cash cycle, business model and the cash needs of any growth component of the business,” Vanderzwan says.
4. Other similar loans
Cash flow loans are similar to other types of unsecured loans such as technology and market expansion loans, but they differ from these loans in key ways.
A technology loan is tied to a specific technology purchase, while a market expansion loan is geared to a specific project that is expected to lead to business growth.
A cash flow loan, on the other hand, is generally used to protect working capital during anticipated growth. Businesses can use a combination of all three types of loans.