Small-time business credit is possible only with two different aspects: cash flow and collateral. They are very important for lenders who are responsible for making structural decisions. Unfortunately, this is one decision that is skipped in most cases related to loans. But the fact is that cash flow and collateral answer different questions fundamentally about the borrower. That is why it is important to understand the differences between cash flow and collateral, so that lenders can decide what works best for them.
Cash Flow and Collateral: What Does Each Approach Answer?
A cash flow is the ability of a business to generate cash through investing, operating, and financial activities. In short, you get to learn about the inflows and outflows of a company through this process. In most cases, these calculations are showcased in a cash flow statement.
So, what a lender looks at in this process is at least three years of historical financial data and normalizes them for one-time items. Sometimes, these details are also included in an instant loan app for both the lender and the borrower to be on the same page.
The final decision is to measure the free cash flow available for debt service. Here, the lender acts as the underwriter of recurrent earnings.
Then comes a collateral, which is an asset that is generally pledged by a borrower to the lender as a guarantee for repayment. In this case, the lender acts as the underwriter of recoverable value. This involves analyzing the borrower’s accounts receivable, inventory, equipment, and real estate.
Then, the same lender applies discounts to different categories and forwards a percentage of the discount total.
In this case, the loan size is decided based on the liquidity value if the borrower defaults the loan.
Cash Flow Vs. Collateral Loans: What Are the Differences?
In most cases, cash flow loans are one step further than collateral loans. They are quite larger as compared to asset-based loans. This also means the borrower gets more flexibility in terms of the use of funds under cash flow loans. However, the only concern is that cash flow loans tend to have a bit longer terms than collateral loans.
The latter, although relatively smaller, are more reliable, especially during the turbulent operating environments. The reason for this is simple: the lender’s protection does not depend on how good the business is performing at the moment.
A Side-by-side Comparison of Cash Flow and Collateral Loans
A loan size and structure changes completely when you choose either sides between cash flow and collateral loans. Here’s a hypothetical scenario where we will look at the calculations properly:
- Annual Revenue: ₹8 crore
- Normalized EBITDA: ₹1 crore
- Eligible Receivables: ₹1.2 crore
- Eligible Inventory: ₹2 crore
- Appraised Equipment: ₹1.5 crore
| Category | Cash Flow Loan | Collateral Loan |
| Loan size driver | 3-4× EBITDA | Sum of all advance rates against eligible assets |
| Indicative loan amount | ₹3,000,000-₹4,000,000 | ₹2,830,000 (₹960K AR + ₹1.2M inv + ₹1.05M equip + facility cap) |
| Typical rate | Prime + 2-4% on senior secured | Prime + 1-3% on revolver, including any monitoring fees |
| Term structure | 5-7 year amortizing term loan | Revolving facility with annual renewal |
| Monitoring intensity | Quarterly financials and annual review | Weekly or monthly borrowing base certificate and periodic field audit |
| What diminishes the loan in a downturn | Earnings always drop below DSCR floor | The asset value drops below any advance rate threshold |
| What the lender does in a default | Pursue guarantee and liquidate any collateral | Liquidate collateral against borrowing base to pursue any kind of shortfall |
When to Choose Cash Flow Lending?
If a business has stable and recurrent earnings, cash flow lending is the right answer. This also applies if the company has a good financial reporting profile. In most cases, the asset base of the business is not enough to fund the actual capital needs, hence the cash flow lending decision.
The companies that generally fall under this category are professional practices, service businesses, software companies, and asset-light operating companies.
The primary advantage of choosing cash flow lending is that the lender does not need to depend on a heavy collateral package. That’s because their decision generally comes from historical earnings of the company, which means the amount borrowed is against the value of the business.
When to Go For Collateral Lending?
A completely different set of businesses are aligned with collateral lending. This generally includes distributors with large accounts receivable balances and manufacturers with meaningful equipment and inventory. Businesses with cyclical earnings and contractors with rolling stock also fit this category.
The good part about a collateral loan is the durability associated with it. A business with a bad quarter still has nothing to worry about because the lender will focus on the assets it has pledged rather than the earnings. So, the company can easily survive an actual operating downturn.
The Bottom Line On Cash Flow and Collateral Lending
Knowing how to lend or borrow on an instant loan app is not enough. Both lenders and borrowers must understand that cash flow and collaterals are not interchangeable products. They have different approaches to different loan types that generally depend on a borrower’s ability to repay, their asset base, and working capital cycle.
There is no hybrid structure between the duo, and lenders basically have to do a lot of underwriting before deciding on the loan type for the borrower.