How to do cash flow financing properly
Cash flow financing is a type of corporate financing in which future cash flows are deposited with the lender as collateral instead of physical assets. Here we show you how cash flow financing works, which companies use it and how it is recorded on the cash flow statement.
Cash flow financing is the financing of a loan through incoming cash flows. This means that the loan instalments are financed directly from the company's income.
Cash flow financing is well suited for companies that have high and stable revenues but few physical assets that they could deposit as collateral with the bank. The collateral for the loan in this case is the expected income during the repayment period.
An IT company provides various cyber security and server maintenance services. It has long-term contracts with several companies, generating regular revenue of £15,000 per month.
In order to further expand its business and offer more services, it needs a bank loan of £100,000. As the company does not have enough tangible assets to put up as collateral, it uses cashflow financing.
The bank approves the loan in the desired amount and a term of three years is agreed as well as an annual interest rate of 5%. This means that the company has to repay a sum of £115,000 over the next 36 months in monthly instalments of £3,194. The stable monthly income of £15,000 serves as security.
All cash flows related to financing activities are recorded in the cash flow statement at the end of the year under "cash flow from financing activities". This includes both incoming and outgoing cash flows, for example:
- Incoming cash flows from financing activities
- Receipt of a bank loan
- Issuance of company shares in exchange for capital
- Outgoing cash flows from financing activities
- Repayment of loans and interest
- Payment of dividends
The outgoing cash flows from financing activities are deducted from the incoming ones. The result can then be positive or negative. Positive means that the company had more incoming cash flows than outgoing ones, for example if it received a bank loan.
If it uses the bank loan for an investment that contributes to an increase in turnover, this is positive. However, if it had to take out a loan because it had to bridge a cash shortage, this is to be seen as negative.
If the result of the total cash flow from financing activities is negative, it means that the outgoing cash flows were higher than the incoming ones. This does not have to mean anything negative.
For example, if a company did not take out a loan or issue shares, no incoming cash flow from financing activities was generated. However, if loan instalments were repaid or dividends distributed, an outgoing cash flow from financing activities was generated. In this case, both correspond to normal processes, which are no cause for concern.
The assessment therefore always depends on the cause of the incoming and outgoing cash flows. They are not positive or negative per se.
For some companies, cash flow financing is the most important way to obtain credit. So-called cash flow loans have the advantage that companies with only a few assets but high, stable revenues can still obtain a loan.
Instead of the assets on the balance sheet, the bank uses the future income as collateral. Companies that offer services therefore often resort to this form of financing.
The amount of credit a bank can grant depends on how high the future cash flows are estimated to be. Companies that can present long-term contracts or have a large volume of accounts receivable have more leeway in cash flow financing, as they can expect higher and stable future cash flows.