Cash Flow: What It Is and Why It Rules Small Business Lending

Cash Flow: What It Is and Why It Rules Small Business Lending

Maybe you’re an entrepreneur with a great idea for a product or service, an identified target market and a knockout startup marketing plan. Or, maybe you’ve been in business for a few years and you’ve gained the insight needed to leverage changes in your industry, gain competitive advantages and grow your business further.

Even with these key areas checked off the small-business-success list, there are two significant things needed to bring your ideas to fruition—funding, and the cash-flow picture that will help you secure it.

What is cash flow?

Whether you plan to obtain small business funding or just want to manage your business as effectively as possible, cash flow is critical.

Cash flow is what is left after you pay all your normal daily expenses. From a lending perspective, “cash flow” represents the total net amount of cash available to the business for servicing debts, as well as growing the business assets. A lender will prepare a cash-flow analysis that demonstrates this over a specific period of time (typically, a year). Your business’s cash flow tells a lender how much debt your business can successfully handle and how much cash flow is left to be reinvested into your business.

Why is cash flow so important to lenders?

Cash flow provides potential lenders with a picture of your business’s financial capacity to pay back a loan—in other words, that your business will bring in enough money to cover the costs of any current financial obligations, as well as the cost of a new loan. As your business grows the cash flow should exceed the amount needed to just pay your debts as you should be using some of that cash flow (the excess) to fund some of your growth without having to borrow. Of all the key factors that lenders consider—including credit history, capital, collateral, cash flow (or capacity) and character—cash flow is always one of the top considerations.

Simply, if cash-flow calculations indicate that a business won’t be able to pay back the loan, then there’s no deal. It’s one of the primary reasons that loans are denied.

How is cash flow calculated?

A lender will evaluate “business cash flow” first. This is calculated by taking the net income or loss earned by the business over any given period, and then adding back any non-cash expenses (such as depreciation and amortization) plus interest paid on other existing debts. This cash flow will then be compared to the principal and interest payment requirements on all your current loans as well as the loan you are requesting. For privately-owned businesses, lenders may also consider “global cash flow,” and will perform a similar type of cash flow analysis for any other businesses of the owner, as well as an analysis of the owner’s personal income and expenses.

A lender may adjust cash flow by taking out non-reoccurring sources of income and adding the business’s non-reoccurring expenses. The lender will need to understand your business and discuss your financial performance with you so that they can identify what unique situations or events may exist or have occurred.

For the lender, it starts with the numbers.

From the lender’s perspective, your financial information (such as tax returns and internally prepared interim financial statements) tells the cash flow story that the loan decision will be based upon. Sometimes the outlook and history of the business that the owner verbally tells the lender does not match the story that their financial information tells. For that reason, accurate accounting is essential. Work in partnership with your accountant to ensure that your business financials truly reflect your business. Otherwise, erroneously represented income or expenses can negatively position your cash-flow analysis. When that happens, lenders must deny applications because they can’t back up the financial risks with reliable paperwork.

It’s important to know, too, that taking on “responsible debt”—debt that has manageable interest rates and repayment terms—is a hallmark of good cash-flow management and ultimately helps businesses grow. Conversely, loans with unreasonable repayment terms or high interest rates erode cash flow and hinder early-stage survival and later growth.

There are three primary ways to improve your business’s cash-flow picture: increase net income, reduce expenses or, in most cases, come up with a combination of both.

  1. If your business is in the pre-launch phase, your cash flow will be a projection based on your best estimates. In that case, make sure they’re as reasonable and accurate as possible. Then, figure out what you can tweak to reduce your startup expenses without compromising your business’s launch and early goals. Keep in mind, too, that at this stage, potential lenders won’t expect your business to show a profit for some time. What they’ll want to see is that you’ve planned accurately and are prepared for ups-and-downs in your business’s revenue cycle.

  2. If you’ve got a year or two of financial history, potential lenders will want to see how you’re planning for and moving toward profitability. Has the business’s net income increased? Do the expenses align with growth goals? Understanding these issues can help you better forecast and plan for purchases and expansions without coming up short in cash on-hand.

  3. With a longer history—say, three years or more—if your cash-flow projections show a business that’s coming up short on available cash over several months (or longer), you need to assess why. It could be as simple as you need capital to help you increase staffing, inventory, marketing or other growth-focused areas, and if you can show how those investments correlate to higher net income, you’ll be able to make a good case with potential lenders. Conversely, you may discover ways to reduce business expenses, such as refinancing high-interest loans.

Accurate cash-flow forecasts are essential to business and borrowing success.

Your historic cash flow is one of the key indicators of current and future business success. If the loan you are seeking is to expand your business and will result in new sources of income, the lender will first look to see if your past cash flow is adequate to repay your expansion debt being requested. You will need to prepare future (projected) cash flow financial statements to show the effect the new loan will have on future income and expenses. Here, again, your accountant is a valuable business advisor to be sure that your future story of growth is accurately represented in the financial projections that need to be prepared.

Understanding and explaining to the lender the ebbs and flows of your business’s cash cycles is critical. Your story for planned future growth is based on the assumptions that you are making which you expect will translate into actual performance. These assumptions need to be understood by the lender and the lender needs to “buy in” to the fact that they are reasonable and attainable. Your assumptions, for both increased revenues as well as expense changes must be supported with sound financial projection. When your story and assumptions for the story are understood by the lender, and the lender sees that these appear to be attainable goals, then you increase your odds of loan approval!