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Accounts Receivable Factoring
A Viable Cash-flow
Solution for Small and Medium-Sized Enterprises
by David
Springer
The pace of change in
today's business environment is inarguably staggering. Growth of e-commerce;
changes to business structures; evolving relationships; changes to funding
arrangements; access to capital and its sources. All occurring at increasingly
exponential rates. Fast. The fact that there is more computing power in the
average notebook computer today than it took to put a man on the moon should
illustrate how fast things change, and whether in senior management or a
business owner you need to keep pace.
In particular, you must stay abreast of changes in your competitive environment,
and remain fully apprised of mechanisms that will enable a response fast enough
to keep you in the game. This article will look at one of those mechanisms,
access to capital and through that, free cash flow. In doing so we'll use an
intuitive framework, peppered with some economics. Why? Intuitive analysis is
ideal for answering specific questions; in this case 'What will best enable my
firm to manage rapid changes to competitive economic conditions and stay in the
game?' And I'll use economics because of Steven Levitt, America's most
outstanding economist under-40, who along with Stephen Dubner considers that 'if
morality represents how we would like the world to work, then economics
represents how it actually does work.'
By speaking to specific anchor points, strategic issues affecting the access to
capital problem can be explored and initiatives developed to allow a timely
solution. In short, it's the fastest and most accurate way to answer the
question you face, because it's easier to understand and doesn't get bogged down
in extraneous, unnecessary analysis.
One of the anchor points in contemporary business is access to capital,
especially when it helps maintain free cash-flow. In many respects they are one
and the same thing, the difference merely being access to capital is a necessary
precursor to free cash flow (you can't use it until you have it). And everyone
needs it. Payroll, materials, overhead, and debtors taking anywhere from 45 to
120 days to settle their accounts, using your firm as a surrogate line of
credit.
Access to capital becomes an even larger issue in the business environment
described earlier, where speed to market and the ability to 'tool-up' (increase
production) are crucial to meeting ever shrinking delivery timelines. Many of us
have experienced the elation of being awarded a large tender, something that
will fill the order book for the next six months, immediately followed by the
hangover that comes with the realization that the firm will struggle to fund the
project based on existing and forecast cash flow.
Small-to-medium enterprises encounter particular problems when it comes to cash
flow and capital access to fund growing operations, to the point where lack of
access is an issue that can threaten continuing operations, even in a rising
market. Balance sheets take time to build, and it is against this security that
banks will lend.
Developing initiatives to tackle this problem involves looking at some existing
options and making a comparison, arriving at a decision that best enables a
solution to the problem at hand. In this instance, a comparison of bank funding
against invoice factoring provides insight into possible solutions for the
capital access / cash flow problem.
Everyday economics can inform this comparison, particularly the study of
incentives - how people get what they want, or need, especially when other
people want or need the same thing. Let's start with banks.
Bank lending requirements are invasive and restrictive. They often engender a
feeling that you have to 'bare all' to borrow a nickel. They would naturally
dispute this claim, but let's return to the incentives - what is their incentive
for lending you money? To earn a return off your efforts. Certainly nothing
short of this, and these days they also use lending as a lever to win the
biggest 'share of your wallet' from their rivals, trying to have you as a
customer for life, 'growing with you and your business.' When you add the fact
that a surplus of people requiring credit exist in the market, they can afford
to be choosy and do the economically rational thing - be risk averse. Risk
aversion drives the mortgage a bank puts on your house to ensure they get paid,
and is what drives them to lend against strong balance sheets. They look at
balance sheets in an accounting fashion, weighing up tangible, realizable,
liquid assets like cash and real property, apply a formula and lend in
accordance with how the result stack up against their risk matrix. Your
continuing success is of interest to them only to the extent that it enables you
to service (and ultimately repay) your debt, generating an ongoing margin on
their investment.
An overly simplistic description, the point being to illustrate that all of this
takes time, and is structured around heavy regulation and evaluation
constraints. Lots of time, and lots of influential rules. First, for you to
build your balance sheet, and second, to get it appraised to a point where your
banker might open or extend your credit facility. During that time, the window
of opportunity to fund that large project, manufacturing expansion, or
operations in a rising market quickly passes, leaving you out of pocket your
application fee and if successful, servicing an even larger debt you might not
need.
Turning to invoice factors, the incentives might seem the same, but how they
view obtaining their return is slightly different. While banks rely on their
acumen in accurately predicting your ability to repay a debt, invoice factors
rely on their skills in accurately assessing the ability of your customer base
to pay you. A lower perceived risk aversion with invoice factors plays a small
part, but it is how the factor views the overall situation that is different
from traditional lending. To begin with, factors recognize your accounts
receivables as assets, just like the bank. The difference is that an invoice
factor considers your receivables a quickly realizable asset, and is prepared to
purchase the rights (and risks) of collecting your outstanding invoices.
Put another way, in economic terms the invoice factor recognizes your
receivables as assets with a future value in cash flow terms, and provided their
assessment of your customers is favorable, they are prepared to effectively
'provide a market' for those assets. This 'market' closes with your transaction
selling them the invoice however; there is no secondary market like junk bonds
or other derivatives.
Access to capital through factors is more expensive than traditional lending,
and this is due to the risk premium attached not to you, but your customer base.
This is not surprising, and you and I would probably do the same. Returning
again to economics and our study of incentives, a rational person requires a
premium for every extra unit of risk they take on. A bigger incentive for a
perceived higher risk. In the case of factoring, the premium is higher than
equivalent bank lending rates, as the risks are considered slightly higher when
the security is not real property, rather a first position claim over all of
your receivables. Your risk exposure is lower than collecting the receivables
yourself (invoice factors are very good at mercantile operations) - the higher
fee charged by the factor compared to the bank is simply the premium you must
pay to lower that exposure.
The difference that factors provide is speed of access to capital, and what
happens when you default. Default on the bank loan, you can lose your business,
even the family home. Factoring is not quite as drastic, although the sums of
money involved are invariably smaller. There are two types of factoring products
available, recourse and non-recourse, and again, the difference comes down to
assumption of risk, and the premium asked to assume the risk of non-payment on
an invoice. With recourse factoring, you remain liable for non-payment by your
customer, and with non-recourse, the factor assumes the risk up to a point, and
at a higher premium.
In summary, there are merits and pitfalls in both traditional lending and
factoring. These are volatile economic times, and having been burnt a number of
times during boom times of the previous two decades, banks are far more risk
averse, holding tight reign on their credit standards. So in light of this
information, we return to our problem, looking to answer the question: 'Which of
these approaches best delivers the flexibility I require to allow me the
opportunity to prosper in a fast-changing business environment?'
For many businesses, the answer lies with invoice factoring, which delivers in
excess of $1 trillion in credit across the continental United States. As with
all business situations there are caveats, or described another way,
arrangements that if not continually monitored can become a comfortable security
blanket that might actually be slowly suffocating you.
It is easy to become accustomed to continuing access to cash flow through
factoring. It is also easy to feel at ease knowing you are backed by a massive
publicly traded institution like your bank. Management and owners of Small and
Medium-Sized Enterprises should continually remind themselves that the study of
incentives works for them too. Constant review of your capital funding and cash
flow arrangements is essential to ensure that the deal you end up with is the
best for your firm, and not others. It's all about getting what you want, or
need, especially when other people want or need the same thing.
About the author: David Springer is a consultant for Sovereign
Funding Group. Sovereign Funding Group is an experienced, reputable company that
offers convenient, no-risk services to help you with the selling of your
deferred payments and business financing including
accounts receivable factoring.
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