Survey data from Goldman Sachs last year shows that 77% of small businesses are concerned about their ability to access capital.
The traditional business lending model leaves many small operators out to dry, especially if they have limited credit history or available collateral.
However, an emerging underwriting model based on cash flow data may help to close this gap.
In this article, we will discuss how this underwriting method works, how it differs from traditional underwriting, and what it means for small and medium-sized businesses (SMBs) trying to get financing.
What is cash flow underwriting?
Cash flow underwriting is a method lenders can use to assess a borrower’s creditworthiness.
As the name might suggest, lenders will use the loan applicant’s cash flow data to assess the credit risk of lending them money.
The cash flow data in question typically refers to the money flowing in and out of the business, which is summarized in the company’s bank statements and transaction history.
Lenders will review and evaluate the borrower’s cash flow data to understand their financial positioning and their ability to repay the loan amount they are requesting.
Cash flow underwriting is a deviation from the traditional underwriting model, which we will discuss in more detail in just a moment.
Notably, cash flow underwriting can be used for both personal and business loans. However, in the context of this blog, we will refer solely to its use for business lending purposes.
Common lending criteria for cash flow underwriting
Lenders using this underwriting method can consider a number of cash flow metrics and criteria when evaluating loan applicants.
This might include:
- Historical revenue trends
- Operating cash flow
- Gross profit
- Current cash flow data from recent bank statements
Keep in mind that the specific benchmarks and criteria necessary to qualify for funding will vary between lenders.
Cash flow underwriting vs. traditional underwriting
Cash flow underwriting for small business loans provides some unique advantages for SMBs trying to secure funding.
To understand the advantages of this underwriting method, it’s important to see how it compares to the traditional approach.
The traditional underwriting approach
The traditional underwriting process for business loans has a large emphasis on credit history.
While this might seem simple enough for large, established businesses, this can pose significant challenges for smaller organizations that are just starting out.
According to data from a National Small Business Association study, 20% of small business loans are denied due to business credit.
In some cases, startup or small business owners with limited credit history may be able to get around these requirements by making a personal guarantee.
This can help a company secure the funding they need, though it places additional risk on the business owner if the company fails and defaults on the loan.
The cash flow underwriting approach
In contrast, cash flow underwriting is more focused on the company’s historical cash flow data and their ability to generate sufficient cash flows in the future to repay the loan.
Thus, even if a company has thin or nonexistent credit, they may be able to qualify for a loan based on their revenue and expense data.
Rather than outright denying companies that don’t meet the lender’s credit criteria, they can still get a sense for the company’s ability to repay the loan based on their cash flows.
For instance, a company that nets $25,000 per month may not have previously borrowed money or used a business credit card.
This company may be denied a loan from traditional lenders that are solely interested in the credit history.
However, a cash flow-based lender might determine that their past earnings and transaction history shows they have the ability to repay the loan.
The impact of cash flow underwriting on SMBs
As illustrated above, cash flow underwriting can positively impact loan approval rates and borrowing terms for small businesses.
Here are some of the ways that cash flow underwriting is advantageous for SMBs:
Better funding accessibility
By considering alternative data, cash flow-based lenders can make funding more accessible to a small businesses and startups.
Though credit history is one of the most common risk indicators traditional lenders use when evaluating loan applications, businesses with no or little credit may still be capable of repaying a loan.
Instead, cash flow underwriting takes into account the business’s operational performance, helping to make up for the significant portion of business owners that would otherwise be excluded from financing.
More favorable loan terms
Even if a business could qualify for a loan under the traditional method, they may be able to secure better terms, such as a lower interest rate, with cash flow data supporting their application.
Another advantage is that cash flow underwriting can support further flexibility tailored to the company’s unique cash flow patterns.
For instance, a seasonal business–like a company that does ski rentals–may secure a variable repayment schedule that aligns with their seasonality.
Support for business development
Companies that are able to access funding through cash flow underwriting can use the capital to spur further growth and innovation, increasing their ability to repay the loan.
This can also create positive ripple effects throughout the economy as these companies receive the capital to grow and hire more employees.
Not to mention, the company will start to build a positive credit history by making on-time payments to the lender.
Potential challenges of cash flow underwriting
Cash flow underwriting is still in the early stages of hitting the market. So, there are some potential roadblocks and challenges of the method that are worth noting:
Length of cash flow history
Though cash flow underwriting can help businesses with little or no credit secure funding, it still requires companies to have a substantial amount of cash flow data for lenders to evaluate.
In exchange for credit data to prove a borrower’s reliability, the lender will still want to see that the company’s cash flows are stable enough to make repayments.
So, companies that have only been in operation for a few months may still have troubles qualifying for a business loan under this model.
Consumer awareness
Cash flow underwriting is still a relatively new option for business financing.
Some business owners may not be aware it exists or what lenders’ requirements are, while others are skeptical of the method altogether.
It may take some more time for consumers to become more familiar with the method and willing to pursue alternative financing options outside of the traditional bank setting.
Technological roadblocks
Traditional lending models that rely on credit history benefit from existing infrastructure and regulations that make it easy for lenders to access data from the major credit bureaus.
On the other hand, sharing cash flow data is a bit more nuanced. It requires consumers to grant access and permissions of their data and accounts to the lender, which can add more friction to the process.
Variations in different service providers and account policies create a lack of standardization that can lead to lower efficiency.
As cash flow underwriting and open banking policies continue to develop, this will likely become more streamlined.
Enjoy flexible underwriting to access the funding you need
Small business owners and finance managers that want to secure funding for their company should be aware of the advantages of cash flow underwriting.
Especially if they’re one of the millions of small business owners that are unable to access funding through the traditional route, cash flow lending can help them secure the capital they need to support operations and grow their business.
With BILL, it’s easy for businesses to secure the credit they need to operate and grow. We use flexible underwriting models to help companies access funding based on their unique circumstances.
See how you can access fast and flexible business credit with BILL by signing up today or request a demo.
