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Definition: Cash-Flow Financing
Cash flow financing is the form of debt in which the bank lends funds backed by the expected cash flows of the company. In general, banks lend funds based on company’s assets which are taken as collateral. This is called as Asset based financing. But in case of Cash-flow financing, the expected cash flows act as the collateral unlike in case of asset based financing in which assets act as collateral. The cash flow financing is generally funded for the purpose of immediate working capital requirements and other operational expenditures such as paying salaries at the end of each month when the receivables have not yet been received. It can also be called a Cash Flow Loan.
To ensure the safe repayment, the bank stipulates various covenants (both positive and negative) with respect to ratios such as Enterprise Value, EBITDA/Sales margin, Interest coverage ratio, Return on Assets, Total Operating liabilities/Total Net-Worth (TOL/TNW), Debt/EBITDA, Capital expenditures etc.
Examples of covenants placed:
• Enterprise Value should not fall less than 75% of the average value since the past 12 months
• EBITDA/Sales margin should not fall to less than 10%
• Interest Coverage ratio should be greater than 2.25
A Comparison of Cash flow-based financing and Asset-based Financing
Asset Based Financing
Not a predictable way of providing capital especially during volatile environment
More predictable way of providing capital to clients
Less reliable form of lending
More reliable form of lending
Cannot be used in case company is in a down turn with bad credit profile, cyclical effect etc.
Can be used even when the company is facing headwinds because of an unfavourable environment
Secured by having covenants on ratios
Secured by long term assets such as machinery, real estate etc.
Used by High margin companies, companies with low physical assets (Services and Marketing companies)
Suited for companies with low margins and large Balance sheets, inconsistent EBITDA,
Since it is based on future expected cash flows, risk is high and cost of financing is higher
As it is based on hard assets whose value is predictable, risk is lower and cost of financing is also less
Such immediate flow of cash for corporations with large working capital requirements but large Receivables period helps in growth of the organisations that do not have enough bargaining power with the buyers and improves the business prospects