December 12, 2022

What is Cash-Flow Based Lending and How Does it Differ from Other Options

Your cash-in-hand stays in your hand!

One of the most significant gaps in the Indian credit market lies in the rigidity of how loans are dispersed and how companies are evaluated for it. This is where cash flow-based lending comes into the picture, focusing solely on a business’s cash flow.

Cash flow-based lending is aimed at filling the credit gap in the MSME sector, which roughly ranges between Rs. 20-25 lakh crore. Therefore, this lending type focuses on alternative financing sources for this particular sector and small businesses.

As such, with the MSME sector contributing to 30% of the Indian economy, Cash flow-based lending becomes pivotal for businesses and the overall economic health.

Quite understandably, this is a concept that can seem foreign to most budding start-up founders. To help, we’ll walk you through this succinct guide to what cash-flow-based lending is, its differences from other forms of lending, when it is required, its types, and how it works. Let’s dive in!

What Does Cash Flow-Based Lending Mean

Cash flow-based lending can be defined as an unsecured loan for a short duration based on a business’s projected cash flow. Leveraging real-time cash flow data allows lenders to reimagine the end-to-end process of lending. It includes underwriting and configuration of credit products, along with repayment.

This means cash flow-based lending can easily remove your dependence on collateral required to assess users. What’s more? Cash flows’ real-time visibility can help you in creating new credit products with smaller ticket sizes, shorter tenure and quicker approval turnaround time. This also entails more flexibility in terms of repayment.

A good example of such a credit product is when the funds’ end-use can be locked. Say a retailer is buying stocks from an FMCG company, and their money is disbursed to the company directly. In this way, it can secure a loan similar to the way an asset-based loan could.

Why is cash flow-based lending becoming sought-after by businesses now more than ever in India, you might ask? Because of a commonplace complaint Indian entrepreneurs come up with i.e., their business is barely growing to live up to its full potential due to a marked paucity of chances to avail debt finance. NBFCs and banks are only interested in extending loans to such businesses that can show fixed assets as security.

As a business strategy, cash flow-based lending is thus gaining traction owing to the challenges of arranging asset-based loans.

In the case of the latter, offered collateral valuation determines the amount of the loan and its tenure.

However, when it comes to cash flow-based lending, the key focus lies in the businesses’ net cash flow. The availability of such cash flow plays an important role in showing whether or not the business would be able to repay its loan. Both the loan amount and the tenure depend on the availability of cash flow.

When Should You Look For a Cash Flow-Based Lending

Any business, especially those operating in the MSME sector that requires short-term working capital loans to meet operational expenses, can opt for cash flow-based lending. The need for this working capital is often about paying rent, administrative expenses, salaries, raw material purchases, business travel and more.

Given the massive credit gap in the Indian MSME sector, this sector can truly leverage cash flow-based lending opportunities to ensure business growth. To be specific, as of August 2022, the credit gap in the sector accounted for roughly ₹20-25 trillion against the outstanding ₹22.3 trillion.

Besides, don’t forget how the COVID-19 pandemic further contributed to the fluctuations in bank credit for the MSME sector. Depending on the intensity of imposed lockdowns, it dropped in some quarters while picking up in others. The answer is clear: this volatility in the financing landscape faced by businesses in the MSME sector can be countered with more focus on cash flow-based lending options.

Let’s find out how cash flow-based lending is truly useful for your business. Many business owners make the common mistake of extending working capital to suffice for business growth activities, winding up with a crunch in cash flow. This scenario can be tackled with cash flow-based lending if:

Your business can show a positive cash flow history even though currently you’re reaching the end of the credit line
You’re developing a new product or growing rapidly but need some time to witness sales growth, recouping different costs entailing R&D, new hires and marketing expense
You need to purchase inventory so that a sudden demand spike can be met
You want to avail of supplier volume discounts but are unwilling to strain cash flow
The top customers of your firm are taking a bit longer than usual to pay invoices

Types of Cash Flow-Based Lending

There are various types of cash flow-based lending options that mimic the collateral-free model of financing. Following are some of them:

Invoice-based financing; This is a form of short-term financing where a loan is extended by a bank or by a lending party based on unpaid invoices.
Buy Now Pay Later: In this method, a merchant receives the full payment of the item upfront minus the fee that the service provider charges
Co-lending: This method ensures that both banks and NBFCs jointly fund a project in which risk is shared by both parties.
Supply-chain financing: This method involves automating transactions and tracking invoice approval and settlement mechanism for buyers and sellers in a supply chain

How Does Cash Flow Lending Work

Cash flow-based lending works in a contradictory manner to traditional asset-based lending. In the latter, payments are based on the collateral and the valuation of assets. However, in cash flow lending, the repayment schedule is decided as per the projected cash flow of a business.

Typically, cash-flow loans are offered by online lenders. Rather than the availability of collateral or relying on the firm’s credit score, these lenders stress on past performance and cash flow projection. This is because, with cash flow-based lending, you borrow money against the amount you’re likely to get in future.

To assess the capability of a borrower to repay the loan, computer algorithms are used by lenders that factor in different sorts of data, including volume and transaction frequency, expenses, seasonal sales, revenue from returning customers, along with even online reviews.

The plus side of this situation is that even if your credit is barely stellar, you can be eligible for a cash flow-based loan, given your sales can cover it. The process of application is generally designed to be hassle-free, and you get to know the decision on loan sanction relatively faster – this could be in a matter of a couple of days or even hours!

In the case of some loans, a percentage of your sales would go to the lender till the loan is paid off. In others, you’d need to make a fixed amount of payments over a predetermined period. This would ensure that you pay the same amount each time.

The downside of cash flow-based lending? Cash flow lenders don’t end up scrutinizing the borrower in the same way as traditional lenders, hence, the investments made by lenders in this space tend to be comparatively riskier. Lenders make up for it by charging much higher rates of interest, along with other fees. While reputable microlenders charge from 10 to 20% interest, the interest rate can go as high as 54% for some other big lenders.

How to Apply for a Cash Flow-Based Loan

Cash flow-based loans provide flexible options for a borrower to choose from. This means that such loans can even be acquired through traditional banks with a business account or via third-party lending platforms or microlenders.

Irrespective of the lender, it is mandatory for a business or an individual to have a detailed income statement prepared before applying for cash flow-based loans. Generally, income statement from the past three business years is preferred for applying for cash flow-based loans.

The final amount dispersed or approved, though, will not always be as per the requirement as various eligibility criteria have to be met. The higher the income stream of a business, the higher would be the loan amount dispersed at a lower interest rate.

Regarding the processing time for such loans, it is relatively short, and online platforms usually disperse such loans within 24 hours. For small businesses, credit history and riskiness of the business are some factors that lenders consider during the loan evaluation stage.

Limitations to Cash Flow-Based Lending

The first limitation of cash flow-based lending is the high fee that is applied. Generally, cash flow-based lending has a high interest rate and higher penalties. The annual percentage rate for cash flow-based lending can be 54% higher than asset-based loans.
The second critical disadvantage is the requirement for personal guarantees. Even though they are unsecured loans, lenders generally place a lien over your entire business in the loan agreement. This means that your entire business serves as collateral under such agreements.
The third disadvantage of cash flow-based lending is automatic payments. Some lenders insist on setting up automated payment schedules. This acts as an advantage for businesses with varying cash flow on a month-on-month basis.
The fourth limitation to cash flow-based lending is the automatic renewal of the loans. Some lenders may automatically renew a loan if it goes past the due date. This burdens the borrower with additional fees, interest payments, and longer payment terms.
The fifth limitation is regarding a healthy credit history. Some lenders may only cater to borrowers with excellent credit scores.
The sixth limitation is that cash-flow-based loans are only good for short-term purposes. As the interest rates and fees are substantially high, such loans are not preferred for long-term investments or expenditures.

Cash flow-based lending has become a huge market for lenders and borrowers alike. With its increasing prominence in the informal and formal economy, your business may opt for it if the need arises. Highly suitable to meet the short-term liquidity needs of a business, such loans are apt for businesses with a healthy cash flow.

Of course, even though such loans are quickly processed, you may face some limitations. Be wary of the fees charged by the lender, the interest rates, and the transparency of the contract you have with them. These details can either play to your advantage or add up to your fixed obligations in the short run.

How BridgeUp can Help

If you are new to the borrower side of cash flow-based loans, look no further. We at BridgeUp provide you with a holistic solution for all your short-term credit needs.

We provide an end-to-end service — from evaluating your creditworthiness to managing your repayments. We ensure that our interest rates are competitive and reasonable for our clients and meet their short-term financing needs.

We also provide a tech-based evaluation of your cash flows to project a fair value of your cash flow estimates on which the loan can be dispersed to your account. As our process is mostly completed within 24 hours, we expect you to get the credit notification from the bank really soon.

Sign up with BridgeUp now or call us at +91-9819660287 to have your cash flow statement evaluated and get a low-interest, low-fee loan.

FAQs

What is the difference between cash flow-based lending and asset-based lending?

In cash flow-based lending, lenders majorly prioritise the past performance of your business and its cash flow projections. However, for extending an asset-based loan, the lenders consider your collaterals and the valuation of your assets.

How high is the interest rate for cash flow-based lending?

While microlenders can offer you cash flow-based loans charging an interest rate between 10 and 20%, the rate can go as high as more than 50% annually for some lenders.

What are the eligibility criteria?

The foremost factor considered by cash flow lenders is the positive history of cash flow of your firm, along with positive projections of cash flow that can aid you in repaying the loan. The eligibility of the borrower almost exclusively depends on the cash flow alone.

When should you opt for cash flow-based lending?

Your firm can opt for cash flow-based lending whenever you need a short-term loan to suffice for your working capital or pay for business growth activities, given you want to avail of a collateral-free loan.