What it means
Traditional bank lending is asset-based: the bank lends against stock, invoices, plant or buildings that can be sold to recover the money. A cash flow loan reverses that logic and lends against the predictable profit stream a business produces each year.
This matters because whole sectors own very few sellable assets. A recruitment agency, a software firm or a dental group may generate millions in annual earnings while owning little more than laptops and a lease, and asset-based lending would offer them almost nothing.
Lenders size these loans using a leverage multiple applied to EBITDA, which stands for earnings before interest, tax, depreciation and amortisation and acts as a rough proxy for annual cash generation. Multiples of two to four times EBITDA are common for ordinary trading companies, with higher multiples for very stable, contracted revenue.
Because the lender has no comfortable asset to fall back on, the protection comes from covenants: contractual promises tested every quarter, such as keeping total debt below an agreed multiple of EBITDA or keeping debt service cover above a set level. Breaching one gives the lender the right to renegotiate terms or demand repayment.
The trade-off is price and sensitivity. Cash flow loans carry higher interest rates than asset-backed facilities, and because the loan size was set from earnings, a fall in earnings raises the effective leverage sharply even though the debt itself has not moved.
A further variant is the unitranche facility, where a single lender provides the whole loan at a blended rate instead of splitting it into senior and junior tranches. Borrowers accept the higher headline cost in exchange for speed and dealing with one counterparty, which is why these structures dominate mid-market acquisitions.
In practice
Real-world examples.
Example
A marketing agency with EBITDA of $1,200,000 and almost no fixed assets is offered a cash flow loan of $3,600,000 at three times earnings. Its old bank, lending only against invoices, had offered a fraction of that.
Example
A subscription software business with $6,000,000 of annual recurring revenue borrows $3,000,000 from a specialist lender, sized at six months of recurring revenue. The lender monitors monthly churn as closely as it monitors profit.
Example
A dental group buys a practice generating $900,000 of EBITDA for five times earnings, or $4,500,000. A cash flow loan of $2,700,000 at three times earnings funds most of it, with $1,800,000 of equity making up the rest.
Formula
Calculation
Maximum loan = EBITDA x agreed leverage multiple. Debt service coverage ratio (DSCR) = EBITDA / total annual debt service.
A specialist IT support company generates EBITDA of $2,500,000 a year from multi-year contracts. Its lender is willing to advance 3.5 times EBITDA.
Loan size = $2,500,000 x 3.5 = $8,750,000.
Interest at 9% costs $787,500 a year, and the loan amortises at 10% of the original principal, which is $875,000 a year. Total debt service is therefore $787,500 + $875,000 = $1,662,500.
DSCR = $2,500,000 / $1,662,500 = about 1.50 times. The loan agreement sets a minimum DSCR covenant of 1.25 times, so EBITDA could fall to roughly $2,080,000 before the company breaches its covenant.Case study
Seen in the real world.
Brightpath Cleaning Services is a fictional commercial cleaning company used here to illustrate how these loans behave. With EBITDA of $1,800,000 from contracts with schools and offices, it borrowed $5,850,000 at 3.25 times earnings to buy out a retiring founder.
Two years later a large council contract was lost and EBITDA slipped to $1,300,000. The debt had barely reduced, so leverage jumped to 4.5 times, well above the four times covenant, and the lender was entitled to act.
In this illustrative outcome the lender agreed to waive the breach in exchange for a higher margin and a pause on dividends. The story shows the defining feature of a cash flow loan: the loan is fixed, the earnings that justified it are not.
Watch out
Common mistakes.
- Assuming a cash flow loan is unsecured. Lenders usually still take a charge over the company's shares and assets; they simply do not expect those assets to repay them.
- Borrowing at the maximum multiple offered. The multiple is a ceiling based on today's earnings, and headroom matters far more than size when trading dips.
- Using an EBITDA figure padded with one-off add-backs. Lenders test covenants against adjusted EBITDA as defined in the agreement, not the flattering number used in the pitch.
Questions
People also ask.
How is this different from asset-based lending?
Asset-based lending sizes the facility from the value of stock, invoices or property, while a cash flow loan sizes it from earnings.
Why are interest rates higher?
Because the lender has weaker recovery prospects in a downturn, so it charges more for taking earnings risk rather than asset risk.
What happens if a covenant is breached?
The lender can demand repayment, but in practice it usually negotiates: a waiver fee, a higher margin, extra equity from shareholders, or tighter reporting.
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