The statistics may say that the U.S. economy is out of recession, but many small and mid-sized business owners will tell you that they’re not seeing a particularly robust recovery, at least not yet.
There are various reasons for the slow pace of recovery among small businesses, but one is becoming increasingly apparent: A lack of cash flow caused by longer payment terms instituted by 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 big businesses have accumulated large cash reserves over the past couple of years by increasing their efficiencies and lowering their costs. In fact, several high-profile large corporations have announced recently that they are extending their payment terms to as long as four months, including Dell Computer, Cisco and AB InBev.
So here’s the picture: Many large corporations are sitting on huge piles of cash and, thus, are more capable of paying their vendors promptly than ever before. But instead, they’re stretching out their payment terms even farther. Meanwhile, many small businesses are struggling to stay afloat, much less grow, as they try to plug cash flow gaps while waiting for payments from their large customers.
How Alternative Financing Can Help
To help them cope with these kinds of cash flow challenges, more small and mid-sized businesses are turning to alternative financing vehicles. These are creative financing solutions for companies that don’t qualify for traditional bank loans, but need a financial boost to help manage their cash flow cycle.
Start-up businesses, companies experiencing rapid growth, and those with financial ratios that don’t meet a bank’s requirements are often especially good candidates for alternative financing, which usually takes one of three different forms:
Factoring: With factoring, businesses sell their outstanding accounts receivable to a commercial finance company (or factor) at a discount, usually between 1.5 and 5.5 percent, which becomes responsible for managing and collecting the receivable. The business usually receives from 70-90 percent of the value of the receivable when selling it to the factor, and the balance (less the discount, which represents the factor’s fee) when the factor collects the receivable.
There are two main types of factoring: full-service and spot factoring. With full-service factoring, the company sells all of its receivables to the factor, which performs many of the services of a credit manager, including credit checks, credit report analysis, and invoice and payment mailing and documentation.
With spot factoring, the business sells select invoices to the factor on a case-by-case basis, without any volume commitments. Since it requires more extensive controls, spot factoring tends to be more expensive than full-service factoring. Full recourse, non-recourse, notification and non-notification are other factoring variables.
Accounts Receivable (A/R) Financing: A/R financing is more similar to a bank loan than factoring is. Here, a business submits all of its invoices to the commercial finance company, which establishes a borrowing base against which the company can borrow money. The qualified receivables serve as collateral for the loan.
The borrowing base is usually 70-90 percent of the value of the qualified receivables. To be qualified, a receivable 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 collateral management fee (usually 1 to 2 percent of the outstanding amount) and assess interest on the amount of money borrowed.
Asset-Based Lending: 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, the business manages and collects its own receivables, submitting a monthly aging report 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, due either to a lack of knowledge or understanding of them or because they believe such financing vehicles are too expensive.
However, alternative financing is not hard to understand-an experienced alternative lender can clearly explain how these techniques work and the pros and cons they may offer your company. As for cost, it’s really a matter of perspective: You have to ask whether alternative financing is too expensive compared to the alternatives?
If you’re in danger of running out of cash while you wait to get paid by large customers and you don’t qualify for a bank loan or line of credit, then the alternative could be bankruptcy. So while factoring does tend to be more expensive than bank financing, if this financing isn’t an option for you, then you must compare the cost to possibly going out of business.
Most business failures occur because the company lacked working capital, not because it didn’t have a good product or service. Unfortunately, this problem is currently magnified for many small businesses dealing with ever-longer payment terms from their large customers. Alternative financing is one possible solution to this common cash flow problem.