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The Advantage of Cash-Flow Data in Small Business Lending

In a profound study published by FinRegLab, the ability of cash-flow data to revolutionize the small business lending landscape has been spotlighted. The research, led by Sabrina T. Howell and Siena Matsumoto from the Stern School of Business, gathered insights from a dataset of over 38,000 small business loans from two fintech lenders, spanning from February 2015 to January 2024. The results demonstrate that using cash-flow data offers a more accurate means of assessing creditworthiness than relying solely on personal credit scores, particularly for budding entrepreneurs and those facing financial restrictions.

Why Traditional Lending Models Fall Short

Lenders have conventionally evaluated small business loans through personal credit scores, which tend to disadvantage newer businesses and those owned by individuals with limited credit history. Alarmingly, about a third of American adults fall into the category of having thin or nonexistent credit files. Additionally, as many as 25% possess below-prime credit scores, a situation that severely impacts their ability to secure financing. This has created a significant barrier for small businesses, especially as banks impose stricter requirements regarding time in business and revenue.

The Study's Key Findings

According to the report titled Sharpening the Focus Using Cash-Flow Data to Underwrite Financially Constrained Businesses, the utilization of cash-flow metrics can predict loan performance with remarkable precision. Some of the study's notable outcomes include:

• - Improved Risk Assessment: Models integrating cash-flow information alongside personal credit data demonstrated enhanced accuracy in estimating default risk across all borrower segments examined. The most significant benefits emerged for entrepreneurs with low credit scores running businesses that had been established for less than five years.

• - Real-Time Financial Insights: Cash-flow data provides lenders with dynamic insights regarding a business's financial health. Key variables include deposits, account balances, and withdrawal trends. Notably, withdrawal behaviors, balance fluctuations, and instances of having low or negative balances were predictive indicators of business financial stability.

• - Broader Access to Capital: By adopting cash-flow underwriting, lenders can extend their reach into previously underserved markets while maintaining proper lending criteria. This data-driven approach empowers banks, credit unions, community development financial institutions (CDFIs), and fintech companies to assess risk more effectively, thereby broadening access to capital for aspiring business owners.

Meeting Policy and Market Needs

As the landscape of small business formation continues to evolve rapidly—with many new ventures promising robust job creation—there is an urgent need for financial institutions to adapt their strategies. The advent of influencer-led companies and various ‘side hustle’ initiatives illustrates the change in how businesses are being structured. This evolution makes it imperative for lenders to embrace innovative underwriting methods.

Melissa Koide, CEO of FinRegLab, emphasizes that cash-flow underwriting is not merely a technical upgrade; instead, it is a practical resolution to long-standing issues in small business finance. The findings from this research not only enhance risk assessment for lenders but also play a crucial role in ensuring that financing options are available and accessible for false entrepreneurs.

Looking Ahead: Future Implications

FinRegLab has also updated its report Transforming Small Business Credit Technology and Data Adoption in Mission-Based Lending, including valuable lessons stemming from pilot programs at five CDFIs and minority depository institutions. By utilizing cash-flow data, these organizations have aimed not just at improving their lending practices but also at tackling the persistent issues of financial inclusion and accessibility in small business financing.

In conclusion, the integration of cash-flow data into lending practices illuminates a pathway towards a more inclusive financial ecosystem—one that fosters entrepreneurship, drives economic growth, and facilitates meaningful opportunities for all. As financial institutions begin to adopt these findings and implement new practices, small businesses will likely find it increasingly easier to access the capital they so critically need. The journey towards equitable financial service delivery is now more achievable than ever, backed by data-driven decision-making that caters to the needs of all economic contributors.