The 5 C's of Credit - Cash Flows
We are discussing the “Five C’s” – ways lenders may evaluate an application for financing. Previously, we discussed character, which focuses on the borrower's experience, but now we move forward to look how the business plan can sustain itself – cash flows.
Cash flow considers the following:
- Where is the money coming from that will repay the debt obligation?
- Where will the money go?
- How much of a cushion will be maintained?
It becomes absolutely crucial to understand the business's financial statements. This holds true for all business stages - startups, existing businesses, and projected growth. Start with understanding all the sources of funds (income). A business will likely have a primary source of income but sometimes there may be secondary source of income.
Once you understand the source of incoming cash flow, then focus upon what the business has to pay out – outgoing cash flows. This includes, but not limited to, cost of sales, salaries & wages, marketing, utilities, taxes, etc. Fixed costs – expenses that do not vary – may be easy to calculate. Using your business goals, calculate the amount of variable costs – expenses that fluctuate with the level of output. Examples of this may include water bills, delivery costs, commissions, credit card fees, etc.
When the business has calculated its profitability (total income less total expenses), will you still be generating a profit if you add on new debt payments? A business does not have to make huge sums of money, but it does need to support the business AND pay the debt obligations due on the loan. There should be a little bit of cushion too so that if poor financial results occur then you can still make the loan payments. While you can look at cash flows and profitability for a period as short as one year, lenders may ask you to estimate or project financial results for three to five years in the future.
Depending upon the type of your business, you may want to share with your lender any seasonality of cash flows. For example, a business may experience high cash inflows during holiday seasons but very slow cash inflows during other parts of the year. Lenders may be willing to work with you, so loan repayments may coincide with seasonal cash flows.
Finally, if accounting or finances are not your strong point, find or hire a person – a family member, friend, or external source such as a certified public accountant (CPA) - who can help you and teach you to understand the business’s financial statements.
Nest Week: Collateral – what is it and why would you need it?