Does Your Small Business Need Cash Flow? Try This…

by Yaro Starak, creator of Entrepreneurs-Journey.com

Entrepreneurship, like most things in life, comes in different forms, shapes and sizes. Today I want to take a quick spin from the internet entrepreneur to the small brick and mortar business owner.

As an internet entrepreneur myself, I sought other income opportunities outside the internet when I started making real money online. Because I am a big proponent of diversification in most aspects of life, in addition to real estate, the capital markets and private business investments, I ventured out and acquired a small business in my community back in the mid 2000s.

As I worked in the business during the initial years, I realized that I needed to pump more money in and increase my working capital levels (day to day cash flow needs) if I wanted to grow and expand fast. However, as we all know money is hard to come by, especially in tougher economic times when banks just do not have the risk appetite to lend.

So I went knocking on the Small Business Administration’s (SBA) doorsteps. I kept knocking and no one opened. So what to do? I continued to contemplate ways the business can increase or accelerate its cash flow so that I can pump more money into its growth. Now I had other funds, but I was not willing to pump those into the business as I wanted the business to self sustain and grow itself.

Small Businesses Can Offer Credit Terms To Customers

Many businesses, especially as they grow, start giving out credit, or basically selling products and providing services in exchange for a promise to get paid down the road. A business does not have to do this, but you will find that in order to stay competitive and earn customer / client loyalty, a business has to compromise in this department.

But how is a small business to continue to fund sales on credit and grow at the same time without having deep pockets? It simply can’t. The business either has to borrow money, or find creative ways to accelerate the cash flow collection from sales of products and services so it can reutilize the tied up cash back into the business.

The Accounts Receivable Factoring Solution

One option that small businesses, who sell on credit, have to accelerate cash flow is through accounts receivable factoring. The term might sound foreign to you right now, but the concept or the nature of the transaction is rather simple.

Receivables factoring is essentially the selling (also called “factoring”) of invoices or receivables to a third part factoring company (also called the “Factor”) to collect the cash today. Let’s walk through a quick example:

Company A (the small business) sells product X to a large Customer B for $10,000. Company A issues Customer B an invoice for $10,000 due 30 days from the sale. Instead of waiting 30 days to collect the cash, Company A finds a Factoring Company C to sell the receivable to. Company A sells the $10,000 invoice to Company C for $9,950. Company A receives $9,950 today, Company C gets to collect the $10,000 from Customer B when the invoice is due, and Customer B is not impacted by the transaction except for the fact that it now pays Company C the $10,000 it owes, rather than to Company A.

Sounds good? Company A receives cash much earlier than it was due, but what about the $50 less that it had to take from Company C? Because there is no free lunch in this world, Company C charged company A $50 to front the cash and bear the risk that Customer B will not come through and pay what it owes 30 days later. This fee is called the factoring fee, or the discount factor in percentage terms.

Let’s assume Company A had a built in profit of $200 on the sale of $10,000 worth of stuff. After paying Company C a factoring fee of $50, it reduced its profits to $150 ($200 minus $50). However, it was able to accelerate receipt of the cash, which it can now use to reinvest back into the business. Clear as mud?

This is precisely what I did to grow my business a few years back. When I acquired the business, it had no large clients. In the course of eight months or so I was able to acquire business from a few corporate customers in the nearby area, and some large contracts with retirement homes and military units.

These large clients preferred me sending an invoice to their billing department, who would then cut a check to my company’s name and send it weeks down the road. Payment terms were typically 20-30 days, with 60 days for the two corporate customers.

Because the large contracts tied up a significant portion of potential “investable” cash, I chose to factor these receivables or invoices to accelerate my cash flow.

Who Does It Cost To Factor Invoices?

There are two main cost components to invoice factoring; the account set up fee and the ongoing discount factor or fee that is paid to the Factor each time a small business sells its receivables.

Because significant time and resources are expended conducting due diligence of the small business, its customers and the quality of its receivables / invoices, the Factor charges the small business a one-time set up fee prior to buying any of its receivables.

Assuming the due diligence process goes smoothly and the Factor is comfortable doing business with the small business, it will charge a factoring fee anywhere between 1-5% of the receivables that it purchases. This fee, also called the discount factor or discount fee, is charged because the Factor has to front the small business its own cash as well as bear the risk that the small business’ customer or client may not pay the invoice down the road when it’s due.

Depending on going market interest rates, as you can imagine factoring can be a cheaper or more expensive option for the small business to raise capital. In many cases however, factoring is the only option when businesses are not able to secure low cost capital. A great option in my humble opinion.

Who Is The Factoring Solution For?

For a small business owner, factoring can accelerate the cash flow needed to procure more inventory, pay creditors sooner to take advantage of early payment discounts, grow the current business or expand into new locations.

Although I am writing this article mainly from a small business owner’s perspective, the factoring solution has a broader application across various industries. For example, a personal notes receivable can be factored to expedite cash collection, which otherwise would have been collected over the course of months and years.

Another example is a structured settlement awarded in an injury claim or lawsuit. The claimant, or recipient of the settlement award may opt to take a smaller lump sum payment today, rather than a cumulatively larger stream of cash flows over months and years.

Why would anyone forgo a significant amount of cash flow over time for a small payment today? There may be several reasons for that, such as paying off large debts such as a mortgage, investing in a business start up or funding a child’s college education.

Similarly, the factoring option is also available to lottery winners. When one wins the lottery, they are given an option of a lump sum payment upfront or an annuity paid over time. This option is essentially what factoring is at its fundamental level.

Although this does not apply to my business, I do want to mention one other use of factoring. A leaner small business may view invoice factoring as a cost of doing business. Why? Because if it were not for factoring, the business has to spend time and resources on collection efforts.

By factoring or selling its receivables to a third party Factor, the business is relieving itself of the responsibility to pursue payment collection, not to mention it alleviates the risk of potential customer default. This is a creative alternative use of factoring transactions.

Concluding Thoughts

The world of financial services and products is a broad one, and factoring is one such option available to small business owners in lieu of bank and SBA loans. I hope you found this broad but complete overview of the accounts receivable factoring process informative and helpful.

If nothing else, I hope you learned something new today, something which you might find applicable to you or someone you personally know either now or down the road.

Sunil
Accelerating Cash

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