Why Factoring?Why Factoring? The answer, in a phrase, is: “cash flow”. Business is all about trade: one entity trading value with another. Normally, that “ value” is money, in the form of cash flow. In a very real sense, for a business owner, the life blood of his business is all about establishing and maintaining cash flow. Michael Gerber, author of "The E-Myth: Why Most Small Businesses Don't Work and What To Do About It", says that 40% of businesses fail in their first year. 80% fail within their first five years. What is the main reason for this?...the lack of adequate cash flow. Understand: It’s all about cash flow, not profit and loss. Knowing, understanding and embracing what comprises your cash flow is the first step to avoiding a cash crisis. Sadly, many businesspersons believe that their business cash flow is defined as revenue minus their expenses. This is simply not true. Revenue minus expenses is an accounting concept. Accounting rules which govern financial statements are not about tracking the actual flow of cash through a business. Rather, they focus on measuring profit or loss -- not cash flow. What does this really mean? It means this: Far too many businesses do not fail because they are unprofitable; they fail because they do not create adequate cash flow. Even the most experienced and intelligent business persons will fail if they make business decisions using incomplete and inaccurate cash balance information. Let there be no mistake about it, a lack of cash flow will threaten a business’ survival. That is the main reason why business failures are not limited to amateurs or people new to the business world. In other words, many businesses' accounts receivable are inadequate. So, why factoring? This is where factoring or selling accounts receivable factoring comes in. Many business owners turn to factoring only when they find their business in financial trouble. They find themselves in need of a quick cash infusion. Take this example: A company – let us say a security guard company - bids on and wins a contract to guard a large construction site. The contract states "net 60 payments" (net 60 means that the security company will permit the customer to wait up to 60 days to pay its bill.) The security company proceeds to fulfill the contract. When the guard company submits its invoice to the construction company, the guard company does not receive immediate payment because it agreed to receive payment 60 days later (…net 60, remember). Meanwhile, the guard company owner still has payroll to meet, bills to pay, supplies to purchase, etc. Yet, his business cash is tied up for at least the next 60 days. So, the business owner has eight more weeks of payroll left to meet as he waits for the construction company to pay. Additionally, he does not have the cash on hand to take on any additional business. The owner needs some business start up funding. In this situation, the company owner has a few unappealing options: Try to acquire a large loan - assuming the business has the credit - or convince his employees to accept a deferred payroll. An increasingly favorable option - in many cases, the best solution - is to strike a deal with an invoice factoring company. What the factoring company will do is effectively buy the business' invoices at a discount - typically, 3% to 4% - and provide the business owner with the up front cash he or she needs. When the accounts receivable come due, the factoring company will then collect the invoices in full. Although the invoice factoring company will collect the receivables, this is usually done in a transparent way to the customer: as far as the customer is concerned, they are simply paying an invoice to a company as they normally would. Or take this example: In order to capture more business, a small manufacturing company offers its potential clients payment terms (…companies which do not offer terms are less likely to get business as opposed to those that do). A particularly large potential customer company wants to do business with the manufacturer. However, it wants terms…good terms. It has demanded 90 day payment periods. Their offer is take-it-or-leave-it. And like most small struggling businesses, the manufacturer cannot afford to let the big account pass by. So, it gives in and offers 90 day terms to the large company. So, the up-side is: the manufacturer has won a large contract. The down-side is: the manufacturer has won a large contract and most of his working capital will be tied up in accounts receivables for at least 90-days. The following examples are all too typical and illustrate a number of issues business owners face and the steps they take to ensure steady cash flow, including acquiring alternate business funding: - Many companies find that they must offer payment terms in order to win business. In this hyper competitive business environment, refusing to offer payment terms is tantamount to refusing the business. Companies are not in the business of refusing business. Therefore, they are “forced” by market place realities to offer their potential customers the best payment plan the company can afford. - Account receivable factoring results in an immediate cash inflow without creating any debt or transferring business ownership. Because of this alternate business funding arrangement, many business owners have become enamored with factoring. Typically, with a regular bank loan or a loan from a traditional financing institution, the business owner may be required to use business interests or assets as loan collateral. In some cases, some financial institutions may require an interest stake in the business in order for the business owner to secure a loan. This does not happen with factoring. - Businesses wanting or needing quick payment from their customers may be “forced” to offer steep cost discounts in exchange for more speedy, timelier payments. For instance, in the above example, in order to get paid faster, the vendor may strike a deal with the customer to receive payments faster (i.e., net 30 instead of net 60) in exchange for lowering his charges. Factoring may be the answer in relieving this type of charge – lowering pressure. - It is vitally important that companies have sufficient cash flow to handle up-front cash commitments, such as meeting payroll, scheduling training, paying bills, ordering supplies, etc. For such cash-strapped businesses, factoring may offer a way to gain a continuous, uninterrupted flow of cash. Since much of these up-front cash commitments are associated with acquiring business, business owners can use factoring to position their business to take on big new orders from their customers. - Account receivable factoring has allowed thousands of small businesses to bid on and win millions of dollars worth of contracts from government and corporate entities. Factoring is recognized as a viable means of ensuring a positive cash flow. - Large corporations have begun to consolidate vendors and are demanding more favorable terms. By doing so, they experience improved liquidity and working capital position. However, for those vendors already squeezed by rising costs (wages, supplies, employee health care, etc), the consequences of granting more favorable terms can be devastating. Many have cash-flow concerns, the largest of which are normally centered on accounts receivable. Factoring can often ease the financial pressure they feel. - In a recent American Express survey, 9% of companies surveyed worried that their cash-flow troubles were bad enough to hamper their abilities to win new business. Without a steady stream of funds to fuel growth, many companies can not continue to expand. This was due in part to findings from another study which found that the percentage of firms paying more slowly than they did the year before rose from 46% in 2003 to 56% in 2004, while the share of sectors lagging in payables jumped to 65% from 45%. In other words, more companies are pushing the limits on payables. This puts financial pressure on those companies owed money. They then turn to factoring as a way to relieve this financial pressure. - An emerging, but growing trend consists of companies instituting a policy of pre-billing on jobs that require substantial up-front costs in order to get paid quicker. They submit their bill up-front to customer companies in order to start the net 30, 45, 60, etc, payment cycle. The earlier they start the cycle the earlier they are paid. - If they can get away with it, vendors try to raise their rates by a few percentage points to offset the costs associated with later payments (net 30, 45, 60, etc) from their customers. Of course, the flip side of this is that they may lose some business in the process. Using accounts receivable factoring, these businesses may be able to eliminate this practice. - Why factoring? Many business owners are rich on paper. They have millions of dollars in accounts receivable, or working capital. What they lack is operating capital. That is why many of them find themselves working with factors rather than banks. Remember: banks have a “picture” or “model” of what they think a prime clients look like. If a company does not fit that picture, it will not receive a loan, and, consequently, will likely not receive the loan (or operating capital) it requires. Factoring changes this picture by turning working capital into operating capital. - Some industries are more “cash intensive” than others. To achieve a positive cash flow, the company’s long-term cash inflows must exceed its long-term cash outflows. Fortune and Zogby International recently conducted a survey of business owners and discovered that 55% of small business owners found it harder to collect their receivables in the preceding six weeks. 60% of those described this as a serious problem because growing uncollected accounts receivables strangles cash flow. Factoring has shown that it can help this situation. - Factoring could have its finest moments in situations such as the following: Let us say you run a small company trying to develop new business. Your marketing department works its potential client list very hard. Then, they hit the jackpot. They finally succeed in landing a huge order – an order that will fill the company’s order book for the next six months. Your sales department then hits a home run when they land a large manufacturing contract. You are overjoyed, but only for a moment. You come crashing down to earth when you realize that you do not have enough money to hire more people, expand your production capacity or order needed supplies to fulfill the order. Your existing and forecasted cash flow is too low. You realize that you will not see any money until the goods are actually delivered. What do you do? The answer just might be factoring. - Bank lending requirements are invasive and restrictive. All too often, they leave you feeling that you have to ‘bare all’ just to borrow a nickel. Then too, these lending requirement change with every turn in the economy. In fact, banks and other lending institutions sometimes change them in anticipation of something happening in the economy. For many businesses, the answer to this problem may lie with invoice factoring, which has delivered in excess of $1 trillion in credit across the continental United States. - Why factoring? Along with its ability to provide continuous, steady cash flow, factoring also provides other business-sustaining benefits. Some of the most profound of these benefits include no loan repayment and the ability to receive discounts cash payments. - Since factoring is not a loan, there is no repayment. Therefore, account receivable factoring relieves the business owner of having to concern himself or herself with repaying any debt, since they have acquired no obligation to do so. - Additionally, there are no revenue-draining late fees associated with factoring. Though this point may seem rather trivial on the surface, the absence of these elements in a business person’s life provides that individual with additional time to concentrate on business building activities. - In providing business start up funding and steadier cash flow, factoring also provides business owners with greater on-hand cash with which to purchase necessary goods and services. Therefore, these business persons are able to take advantage of discounts many vendors provide for cash payment. And, as any good business person knows, any money saved is like cash in the bank.
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