Statistics may say that the US economy is coming out of recession, but many small and medium-sized business owners will tell you that they are not seeing a very strong recovery, at least not yet.
There are various reasons for the slow recovery among small businesses, but one is becoming increasingly clear: Lack of cash flow caused by longer payment terms from their vendors. Dealing with slow paying customers is nothing new for many small businesses, but the problem is exacerbated in today’s sluggish economy and tight credit environment.
This is ironic given the fact that many large businesses have accumulated large cash reserves over the past few years by increasing their efficiency and lowering their costs. In fact, several well-known large companies have recently announced that they are extending their payment terms by up to four months, including Dell Computer, Cisco and AB InBev.
So here’s the picture: A lot of big companies are sitting on huge piles of cash and, as such, are better able to pay their vendors right away than ever before. But instead, they extend their payment term even further. Meanwhile, many small businesses struggle to stay afloat, let alone grow, as they try to close cash flow gaps while waiting for payments from their big customers.
To help them overcome this kind of cash flow challenge, more small and medium enterprises are turning to alternative financing vehicles. This is a creative financing solution for companies that don’t qualify for traditional bank loans, but need a financial boost to help manage their cash flow cycle.
Startups, fast-growing companies, and those with financial ratios that do not meet bank requirements are often excellent candidates for alternative financing, which usually takes one of three different forms:
Factoring: With factoring, businesses sell their outstanding receivables to a commercial (or factor) finance company at a discount, usually between 1.5 and 5.5 percent, which is responsible for managing and collecting the receivables. Businesses typically receive 70-90 percent of the value of the receivables when selling them to the factor, and the remainder (less the discount, which represents the factor’s cost) when the factor collects the receivables.
There are two main types of factoring: full service and factoring. With full-service factoring, a company sells all of its receivables to a factor, which performs many of the services of a credit manager, including credit checks, credit report analysis, and invoices and shipping and payment documentation.
With factoring, businesses sell specific invoices to factors on a case-by-case basis, without any volume commitment. Because it requires broader control, factoring tends to be more expensive than full service factoring. Full recourse, non-recourse, notification and non-notification are other factoring variables.
Accounts Receivable Financing (A/R): A/R financing is more like a bank loan than factoring. Here, the business submits all of its bills to a commercial finance company, which establishes a lending base on which the company can borrow money. Qualified receivables serve as loan collateral.
The basis of the loan is usually 70-90 percent of the value of the eligible receivables. To qualify, receivables must be less than 90 days old and the underlying business must be deemed creditworthy by the finance company, among other criteria. The finance company will charge a guarantee management fee (usually 1 to 2 percent of the amount owed) and an interest rate on the amount borrowed.
Asset-Based Loans: This is similar to A/R financing except that the loan is secured by business assets other than A/R, such as equipment, real estate, and inventory. Unlike factoring, a business manages and collects its own receivables, submitting monthly aging reports to the finance company. Interest is charged on the amount of money borrowed and certain fees are also assessed by the finance company.
Overcoming Fears and Objections
Some businesses shy away from alternative financing vehicles, either because of a lack of knowledge or understanding of them or because they believe they are too expensive.
However, alternative financing is not difficult to understand—an experienced alternative lender can clearly explain how these techniques work and the pros and cons they may offer your company. Regarding cost, it’s actually a matter of perspective: you have to ask whether the financing alternative is too expensive compared to other alternatives?
If you are in danger of running out of cash while you wait to be paid by a major customer and you do not qualify for a bank loan or line of credit, then the alternative is bankruptcy. So, although factoring tends to be more expensive than bank financing, if this financing is not an option for you, then you should compare the costs with the possibility of going out of business.
Most business failures occur because companies lack working capital, not because they don’t have a good product or service. Unfortunately, this problem is currently being magnified for many small businesses dealing with longer payment terms than their large customers. Alternative financing is one possible solution to this common cash flow problem.