Cash-Flow Based Lending

Cash-Flow Based Loans

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Cash-Flow Based Lending

Cash-flow based lending is secured or unsecured financing whose primary source of interest and principal payment are the cash flows from a bor­rower’s operations.  Unlike asset-based lending, where the source of loan repayment is the dedicated cash flows from the cash conversion of the financed assets that secure the loan, the principal source repayment of cash-flow based loans is the cash flow from the borrower’s operations.  Banks lending on a cash-flow basis look first to the cash flow and then to the business’s assets for repayment.  There are a variety of cash-flow based loan structures.  Cash-flow based lending is structured as a revolver or term loan with a bullet or amortizing maturity and can vary greatly from lender to lender and borrower to borrower.

Cash-flow based lending is commonly unsecured but may also be secured by the pledge of assets.  Unsecured lending inevitably involves a much higher degree of risk than secured lending since loan repayment is completely dependent on the borrower’s intention and ability to repay.  Therefore, the market for unsecured cash flow financing is limited since secured lenders have a prior claim on the firm’s assets.

Because cash-flow lender look first to the borrower’s cash flow from operations and then to any pledged assets for the repayment, cash-flow based lending typically requires fewer collateral controls, monitoring and reporting but more financial covenants than for asset-based lending.  Viewed to be a higher risk loan due to the common lack of collateral and a generally lower recovery rate, unsecured cash-flow based lending typically carries a higher interest rate margin than asset-based lending.

With cash-flow based lending, the lending bank attempts to measure the borrower’s capacity to generate future operating cash flow for debt servicing.  The size of a cash-flow based loan is generally limited to a multiple of the borrower’s EBITDA (earnings before interest, taxes, depreciation and amortization) or other leverage multiple used to measure a company’s cash flow and ability to service its debt, such as the debt service coverage ratio (DSCR).   The available credit is capped by a leverage multiple.  The violation of covenants can result in the renegotiation of the credit agreement, additional fees or termination of the loan.

According to multiple lending sources, cash flow spreads for deals with over $75 million in EBITDA got as low as the mid-300s over Libor during the 2005 to 2007 time frame.  In 2009, those same deals were being priced in the Libor +600 range; since the end of 2009, the spreads have moved down to Libor +450 with a Libor floor of 200 basis points.[1]

Cash-flow loans are generally better suited for companies with stable cash flow trends with a consistent operating performance and stable credit history.

Specialized Lending ­– Commercial Cash Flow-Based Finance

Under the IRB approach set out in the Basel II Accord issued by the Basel Committee on Banking Supervision (BCBS), banks must categorize banking-book exposures into broad classes of assets with different underlying risk characteristics.  Specialized lending is the collective term under the Basel II IRB framework for several sub-categories of commercial cash flow-based finance, whose repayment is dependent primarily on the cash flows and the value of the underlying collateral. 

Within the corporate asset class, the Basel II Accord separately identifies five sub-classes of specialized lending.  Specialized lending possesses all the following characteristics, either in legal form or economic substance:

  • The loan exposure is typically to an entity (often a special purpose entity [SPE]) created expressly to finance and/or operate physical assets;
  • The borrowing entity has little or no other activities or material assets of its own, with little or no independent capacity to repay the exposure apart from the income that it receives from the financed asset(s);
  • The terms of the financing give the lender a substantial degree of control over the asset(s) and the income that it generates; and
  • The primary source of repayment of the financing is the income generated by the asset(s).

On the basis of these characteristics, specialized lending operations are assessed differently from conventional companies.  In contrast to lending to conventional companies, the credit assessment of specialized lending focuses on the assets financed and the cash flows expected from those assets, not on the borrower.

The five sub-classes of specialized lending are project finance, object finance, commodities finance, income-producing real estate, and high-volatility commercial real estate.

Project finance (PF) is specialized lending that is generally repaid virtually exclusively from the proceeds of contracts signed for the project’s products, with lenders looking primarily to the revenues generated by the project both as the source of repayment and as security for the loans.  Repayment depends primarily on the project’s cash-flow and on the collateral value of the project’s assets.  The borrowing entity is usually a special-purpose entity (corporation, limited partnership or other legal form) that is permitted to perform no other function than developing, owning and operating the project.  Project financing is commonly used for large, complex and expensive projects, such as power plants, chemical factories, mining projects, transport infra­structure projects, environmental protection measures, media, and telecommu­nications projects.  It may take the form of financing of the construction of a new capital installation or the refinancing of an existing installation, with or without improvements.

Should payment difficulties arise, the collateral value of project assets and the estimated resulting sale proceeds will be decisive for the credit institution.[2]

Object finance (OF) is specialized financing used for the acquisition of assets other than real estate, such as ships, aircraft, satellites, railcars, and fleets, where the repayment of the financing is dependent on the cash flows generated by the specific assets that have been financed and pledged or assigned to the lender.  Rental or leasing agreements with one or more contract partners are a primary source of these cash flows.

The type of assets financed can serve as an indicator of the general risk involved in the object finance transaction. Should payment difficulties arise, the collateral value of the assets financed and the estimated resulting sale proceeds will be decisive factors for the credit institution.[3]

Commodities finance (CF) is structured short-term specialized lending used to finance reserves, inven­tories and receivables of exchange-traded commodities (e.g., agricultural crops, crude oil or metals) where the exposure will be repaid exclusively from the proceeds of the sale of the com­modity and the borrower has no independent capacity to repay the loan, which is the case when the borrower has no other activities and no other material assets on its balance sheet. The financing is structured to compensate for the borrower’s weak credit quality.  The exposure’s rating reflects its self-liquidating nature and the borrower’s skill in structuring the transaction.

One essential characteristic of a commodities finance transaction is the fact that the proceeds from the sale of the commodity are used to repay the loan. Therefore, the primary information to be taken into account is related to the commodity itself. If possible, credit assessments should also include the current exchange price of the commodity as well as historical and expected price developments. The expected price development can be used to derive the expected sale proceeds as the collateral value. By contrast, the creditworthiness of the parties involved plays a less important role in commodities finance.[4]

Income-producing real estate (IPRE) is specialized lending used to fund the construction or acquisition of such income producing commercial real estate as multifamily residential buildings, office buildings to lease, retail space, industrial or warehouse space, and hotels, where the prospects for repayment and recovery on the financing depend primarily on the cash flows generated by the asset in the form of rental or lease payments generated from the tenants or the sale of the asset.  There are four broad types of income-producing real estate (i.e., offices, retail, industrial and leased residential) and many other less common types (e.g., hotels, mini-storage, parking lots and seniors housing). The borrower may be special purpose entity (SPE) focused on real estate construction or holdings or an operating company with sources of revenue in addition to real estate.

As the loan is repaid using the proceeds of the property financed, the occupancy rate will be of particular interest to the lender in cases where the property in question is rented out.[5]

Local banking supervisors may categorize certain types of income-producing commercial real estate exposures as HVCRE. High-volatility commercial real estate (HVCRE) is specialized lending used to finance commercial residential and commercial real estate that experiences higher loss rate volatility compared to other kinds of specialized lending, with the source of loan repayment dependent on cash flows from unknown sources or the future sale of the property.

HVCRE includes:

  • Commercial real estate exposures that are secured by properties of types categorized as sharing higher volatilities in portfolio default rates;
  • Loans financing any of the land acquisition, development and construction (ADC) phases for real estate properties of those types in such jurisdictions; and
  • Loans financing acquisition, development and construction of any other real estate where the source of repayment at origination of the exposure is either the future uncertain sale of the property or cash flows whose source of repayment is substantially uncertain, unless the borrower has substantial equity at risk.

References, Bibliography



[1]. Smith, Harris. The debt effect. Grant Thonton, 2010. Web. 19 May 2013. [PDF]
[2]. Oesterreichische Nationalbank. Rating Models and Validation. OeNB, Nov. 2004. Web. 20 May 2013. [PDF]
[3]. Ibid.
[4]. Ibid.
[5]. Ibid.


Autin, Gregory. Commercial & Corporate Credit. Baden, Austria: Gregory Autin & Co KG, May 2013. Print.
Basel Committee on Banking Supervision. Working Paper on the Internal Ratings-Based Approach to Specialised Lending Exposures. BIS, Oct. 2001. Web. 20 May 2013. [PDF]
Basel iii Compliance Professionals Association. “Basel ii Accord Section 211 to 230, III. Credit Risk ─ The Internal Ratings-Based Approach”. BiiiCPA, n.d. Web. 20 May 2013. [HTML]
LoPucki, Lynn M. The Unsecured Creditor's Bargain. HeinOnline, 1994. Web. 19 May 2013. [PDF]
Oesterreichische Nationalbank. Rating Models and Validation. OeNB, Nov. 2004. Web. 20 May 2013. [PDF]
Standard & Poor’s. A Guide to the European Loan Market. McGraw-Hill, Feb. 2012. Web. 18 May 2013. [PDF]
United States. Federal Reserve Board. Commercial Loans. Sept. 1997. Web. 24 May 2013. [PDF]
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External References

EU Federation – Glossary on factoring and commercial finance in English with translations into German, Polish, Spanish, Italian, Portuguese, French and Greek [HTML]
Federal Reserve (Fed) – “How do you define ‘Commercial Loans’ and what is the economic importance of these types of loans?” [HTML]
Federal Reserve (Fed) – Branch and agency examination manual on commercial loans [PDF]
National Association of Realtors (NAR) – The Third Consultative Paper on the new Basel Capital Accord — Letter on the Basel II Capital Accord to Basel Committee on Banking Supervision [PDF]
Balthazar, Laurent. From Basel 1 to Basel 3 — The Integration of State-of-the-Art Risk Modeling in Banking Regulation. Palgrave Macmillan, 2006. Web. 17 May 2013. [PDF]
Office of the Comptroller of Currency (OCC) – Comptroller handbooks on commercial credit [HTML]
Small Business Administration (SBA) ­– U.S. Small Business Administration information on commercial finance [HTML]
Standard & Poor’s – A Guide to the Loan Market [PDF]

Tools – Business calculators, including cash flow calculator, inventory analysis, working capital needs and more [HTML] – Loan calculators, including amortizing loan calculator, balloon loan calculator, loan comparison calculator and more [HTML]
Fannie Mae – Financial calculators, including a refinance, repayment plan, modification, forbearance, loan-to-value, debt-to-income, and mortgage calculator [HTML] 
Mortgage & Finance Association of Australia (MFAA) – Loan calculators [HTML]
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