Why Your Small Business Cash Flow Is Important For Funding

Business tips for cash flow

Maybe you’re an entrepreneur with a great idea for a product or service, an identified target market, and a knockout marketing plan. Or, maybe you’ve been in business for a few years, and you’ve acquired 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 small business cash flow picture that will help you secure it.

What is cash flow?

Whether you’re looking for funding for your business or just want to manage it effectively as possible, cash flow is critical.

Cash flow is what’s 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 (typically, a year). Your business’s cash flow tells a lender how much debt your business can successfully handle and how much 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 ability to pay back a loan. In other words, it shows that your business brings in enough money to cover the costs of any current debt your business has in addition to the cost of a new loan.

As your business grows your small business cash flow should exceed the amount needed to just pay your debts. This is because you should also be using some of your small business’s cash flow to fund some of your growth without having to borrow. Of all the key factors that lenders consider, cash flow is always one of the top considerations.

How is cash flow calculated?

A lender will evaluate “business cash flow” first. Most lenders rely on the most recent tax return as a starting point for the cash flow calculation. They look at the relevant IRS business tax form (form 1120S for S Corps, 1120 for C Corporations, 1065 for LLCs) or personal tax return for sole proprietorships (Schedule C).

Annual cash flow is calculated by taking the net income or loss earned by the business over a year 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 annual principal and interest payment requirements (also known as debt service) on all your current loans as well as the loan you are requesting. Lenders refer to this ratio of cash flow to debt service as the Debt Service Coverage ratio.

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 its financials 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 don’t match the story that their financial information tells. For that reason, accurate accounting and proper tax filings are essential.

Work in partnership with your accountant to ensure that your business financials truly reflect your business. Otherwise, it can distort your small business cash flow picture. 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.

Improving your cash flow and chances of being approved for a loan

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 your 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 (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 working capital to help you increase staffing, inventory, marketing, or other areas. 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 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 business’s future 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 are 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 they need to agree that they’re reasonable and attainable.

Your assumptions, for both increased revenues as well as expense changes must be supported with sound financial projections. 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!

Different banks have different debt service coverage ratio requirements. According to the Small Business Finance Institute, lenders typically require a minimum debt coverage ratio of 1.25. In other words, for every $1 of debt, the business has 25% more cash flow available to serve as a cushion. The debt service coverage ratio is an important measurement lenders consider when evaluating a business loan.

Pursuit is here to help!

As a community lender with over 15 different loan products, Pursuit can be more flexible on debt coverage ratio requirements which can increase your likelihood of being approved for a loan. We can also help you improve your debt coverage ratio by reducing your existing monthly debt payments and increasing your cash flow through refinancing. Reach out to us today to see how we can help your business grow!

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