Maintaining the working capital necessary to stay on top of day-to-day expenses is a challenge that all businesses face. However, it can be particularly troublesome for companies that can’t qualify for traditional financing. 

Cash flow loans are more accessible than many other types of business funding, but they have some significant downsides. Here’s what you should know about them, including how they work, what you need to qualify, and when they’re a good idea.

What Is a Cash Flow Loan?

A cash flow loan is a type of financing businesses use to meet their working capital needs, such as a merchant cash advance or invoice financing. The proceeds typically go toward necessary operating expenses, such as rent, utilities, payroll, or inventory.

In addition, the underwriting for these loans focuses on the borrower’s cash flows instead of their personal or business credit scores, and the lender often agrees to take a portion of your expected cash flow to repay the debt.

Because cash flow lenders primarily use a prospective borrower’s revenue or net income to determine whether they qualify for financing, they’re best for businesses that can’t get a loan from a bank but have strong cash flow.

Cash flow financing funds more quickly than average, which also makes them attractive when you need an influx of cash as soon as possible. You can often get the funding for a business cash flow loan immediately after your lender approves you.

Like many alternative sources of business financing, cash flow lending options tend to have a higher financing cost than traditional bank loans. They may also include prepayment penalties that make sure you pay all the cash flow finance charges.

How Does a Cash Flow Loan Work?

Businesses typically seek out cash flow loans when they need an influx of liquidity to sustain their operation or pursue a growth opportunity. They’re usually not something you’d want to use if another route forward is available.

In many ways, cash flow loans play a role similar to payday loans for consumers. They’re not a sustainable source of long-term funding, but they can provide easy access to fast cash in an emergency if you’re willing to pay the steep price.

They also have relatively short repayment terms, and the lender typically takes the loan payments directly out of the borrower’s bank account.

For example, say you open up a restaurant. A year into your operation, you can maintain a positive cash flow, but struggle to keep pace with local demand. Fortunately, there’s an opportunity to expand your business into the space next door.

You don’t have cash flow problems, but you still lack the funds to make the new location serviceable. You try to go to the local bank for a loan, but they won’t work with you because you’ve only been in business for a year.

To get the working capital loan you need, you decide to get a merchant cash advance for $40,000. The lender approves your short-term loan after they review your cash flow statement and see that you’ve been profitable for the last year.

In exchange, they charge you a 3% origination fee and 36% interest per year for the next three years. To collect their payment, they’ll automatically take 3% of your sales until you’ve paid off the balance.

What Do You Need To Qualify for One?

One of the primary advantages of cash flow loans is that qualifying for them is often easier than getting a business loan from a traditional financial institution, at least when it comes to minimum credit scores.

However, you usually need to meet requirements in the same three areas that you have to for other forms of business financing: credit, time in business, and profitability. Usually, the latter is the most significant hurdle to clear.

For example, Credibly offers working capital loans to small businesses. To qualify, you need to have a credit score of 500 and be in business for six months, both of which are easily attainable.

However, you also need to average $15,000 in monthly bank deposits, which is significantly more challenging, especially if you’ve only been in business for six months.

If you meet a cash flow lender’s minimum requirements, you should qualify for a loan. Most of them have an automatic application and underwriting process, which is why they fund so quickly.

However, barely clearing them means you’ll probably get the least favorable terms they have to offer, including the highest interest rates.

For example, OnDeck requires that you have a 600 personal credit score, be in business for at least a year, and bring in $100,000 in revenue each year.

However, they claim that their typical borrower has a personal FICO score above 650, has been in business for more than three years, and brings in $300,000 per year. With those qualifications, you’d likely see noticeably lower finance charges.

What Is the Difference Between a Cash Flow Loan and an Asset-Based Loan?

Cash flow loans are an unsecured form of financing. There’s no collateral involved, and you typically qualify primarily through your business’s profitability. Cash flow lenders care most about your cash flow projection during underwriting, hence their name.

Asset-based loans are the opposite. Their lenders require that you provide collateral that they can seize to recover their losses if you default on your debt. The assets vary, but it could be your:

• Inventory
• Accounts receivable
• Property or equipment

Because asset-based lending involves collateral, it’s a much safer financing activity for lenders than cash flow lending. As a result, asset-based loans typically have lower interest rates and fees.

If your business has low cash inflow but valuable capital assets, an asset-based term loan may be a better way to fix your cash flow problem than a cash flow loan. Business owners with bad credit can often overcome their lack of creditworthiness with collateral.

If you need to build business credit, consider using a credit builder loan, like Credit Strong’s.

Pros of Cash Flow Loans

Cash flow loans are far from perfect, but they can be an attractive financing option to many businesses for several reasons. These are the most significant benefits they have to offer.

Meet Your Working Capital Needs

If your business has any necessary operating expenses, you have to maintain some level of capital to stay afloat. When you don’t have the cash reserves to cover those costs, that money must come from external financing.

Cash flow loans can get you the funding you need for expenses that are critical to your operation, like rent or payroll. You can also use them to take advantage of a growth opportunity and scale your business.

Flexible Qualification Requirements

Unfortunately, many businesses that need funding the most can’t get it from traditional lending institutions. Banks have strict qualification requirements and usually refuse to work with new companies or those whose owners have bad credit.

However, cash flow loans are much more accessible. You don’t have to be in business for very long or have a good credit score to qualify. If your business is profitable, you can probably get funding from a cash flow lender.

Fast Funding

Acquiring business financing from a traditional financial institution is a lengthy endeavor. You have to gather the necessary documentation, fill out an application, and wait for the bank to complete the underwriting process and transfer your funds.

You can’t always afford that time. If you need money to keep your business from going under or to take advantage of a time-sensitive opportunity, a cash flow loan can get you the funds you need more quickly.

The application and underwriting are less intense than with lenders that are more credit-focused. They’ll also usually transfer the proceeds right after approving your application.

Cons of Cash Flow Loans

Cash flow loans can provide some much-needed working capital, but they shouldn’t be your first choice for funding. Here are the most significant drawbacks to consider before applying for one.

High Finance Charges

Like many other kinds of alternative financing, cash flow loans are much more expensive than the business loans you’d get from a bank. Not only are their interest rates significantly higher, but they also tend to carry some hefty fees.

For example, OnDeck offers short-term cash flow loans for up to $250,000, but they come at a steep price. Their interest rates start at 35%, and there’s a hefty origination fee for all first-time customers.

As a result, the average annual percentage rate (APR) for their business loans in 2021 was 54.96%. In comparison, you can get an unsecured loan for up to $100,000 from Bank of America with a flat $150 origination fee and an interest rate as low as 4.75%.

Possible Prepayment Penalties

In many financing arrangements, you can reduce your total cash outflow by paying down your loan amount ahead of time. If you can afford to pay off the remaining balance early all at once, the lender may waive your remaining interest payments.

Unfortunately, cash flow loans often have prepayment penalties that prevent you from exercising that option. The lenders want their profits, and they don’t let you get around their finance charges by paying them back early.

Automatic Loan Charges

Cash flow lenders often require that you give them direct access to your bank account so they can collect payments from you automatically. That might not sound like a problem, but it can be risky.

If you agree to fixed loan payments and the lender tries to collect one at an inopportune moment, you might not have enough funds in the account. That can result in expensive insufficient funds fees.

Alternatively, they might take a percent of your daily or weekly sales. That negative cash flow won’t result in insufficient funds fees, but it can impact your ability to pay for your other obligations and leave you with a cash-flow gap.

Alternatives to Cash Flow Loans

Cash flow loans can be a helpful tool if you have no other way to meet your working capital needs, but their costs might be higher than you can afford. Fortunately, there are alternative ways to get financing, even if your business is new or you have bad credit.

For example, consider the following:

• Credit cards: While they aren’t great for long-term financing, credit cards can help you manage your business’s cash flows. Many don’t have time-in-business requirements, and options are available for people with less-than-perfect credit scores.
• Microloans: The Small Business Administration’s (SBA) microloan program provides loans up to $50,000 to help small businesses grow. You may be able to get a microloan from an SBA-approved non-profit lender for a new business, even if you have bad credit.
• Equipment loans: If you need to fund the purchase of new equipment, you can usually find a lender offering equipment loans with less strict qualification requirements. The asset serves as collateral, making it a secured loan. As a result, the lender may feel more comfortable lending to riskier borrowers.

Cash flow loans shouldn’t be the first place you look for a business line because of their high finance charges. Try to get a small business loan from a traditional institution or find an alternative financing source that’s more affordable first.

That said, if you’re having cash flow issues and need funds to stay afloat or to take advantage of an opportunity, it may be worth the cost. Just make sure you can afford the future cash flow drain they represent before you sign.

CreditStrong for Business is the only 0% interest business credit builder in the nation

Start Building