How to prove your business has healthy cash flow to get financing
If you show a potential lender that your company has a steady cash flow and an effective business plan, you may be more likely to obtain credit.
As a small business owner, you need to approach any meeting with a lender the same way you would a potential investor meeting. First and foremost, you will need to detail the operating cash flow to help lenders understand your business credit needs, but you may also be required to present an effective business plan.
Here's how to show lenders your business is a good and low-risk investment.
Analyze your current operating cash flow
Before applying for business credit, review your past cash flow statements and develop a realistic operating cash flow projection that demonstrates you can safely incur debt. If you're new to developing operating cash flow projections, use this template to get started.
"Lenders typically look for two things when determining how much debt a small business can incur: total debt compared to net worth and debt service coverage ratio," says Mike Strathman, division lending manager at Wells Fargo.
While numbers can vary based on how much money businesses in your industry need to provide goods and services, Strathman recommends that total debt not exceed three to four times the net worth of your business. In other words, if your business is worth $150,000 based on your assets in your balance sheet then you would be looking at keeping your debt to less than $450,000 to $600,000.
Strathman also suggests showing a debt service coverage ratio — the amount of cash flow or net operating income available to cover obligations and debts — of 1.25%, or enough to cover 125% of all obligations. This means you should look to generate at least $1.25 in cash flow to cover every $1 in debt payments.
"If a small business can prove strong performance over the previous 12 months, most lenders predict that this can be repeated over the next 12 months," Strathman says.
"Your business plan and cash flow projection should show that you can win the customers and collect the receivables needed to build revenue."
Improve your marketing/sales strategy and receivables management for your cash flow projection
Your business plan and cash flow projection should show that you can win the customers and collect the receivables needed to build revenue and achieve a solid debt service coverage ratio.
If your small business sells widgets off the shelf, you need to prove that you can attract and convert a broad base of customers while keeping your shelves full. Alternately, if you provide consulting services for widget manufacturers, you need to prove that you can speed payments owed by clients. Assess how you can better control inventory and speed up receivables by looking at the efficiency of your sales process and how you track shipments.
Prepare your books to show operating cash flow
As your small business grows, and your need to obtain credit becomes greater, the type of financial statements you need to present to lenders will evolve.
"At the smaller end of the market, usually for credit of $100,000 or less, lenders will often accept self-prepared tax returns," Strathman says. "As you get higher up, the needs of the lender will change, from requiring CPA-compiled to CPA-reviewed to CPA-audited books."
To obtain credit, you will need to provide historical business financial statements that show a track record of past performance and a strategy and/or business plan offering confidence that you can do it again. You'll also need to provide financial projections and your assumptions that show a solid operating cash flow projection in future years as a result of the project and the loan. If your business plan offers these elements in a realistic way, you will be in a much better position to secure the credit that's essential for your business to survive and succeed.
Once your cash flow is in a better spot, you can think about whether now is the right time for you to apply for credit.