Why using invoice factoring is a smart business move
Many businesses struggle to have enough money on hand to meet financial obligations. This is the definition of a “cash flow” problem. To address this problem, companies generally take one of two approaches:
- Using other people’s money (OPM), that is, borrowing; gold
- “Start up” the business using your own assets and financial resources.
Most business owners instinctively look to loans as the solution. This article looks at Bootstrapping as a viable alternative.
other people’s money
The use of OPM implies equity financing (selling a part of the business and therefore part of its autonomy) or debt financing (borrowing). This article focuses on debt financing.
“Debt” is money owed to another person or institution. If used to address a cash flow problem, it can be a drag on a business. When a business “borrows” money (that is, takes out a loan), it incurs a debt that must be repaid. The repayment includes both principal (the amount borrowed) and interest (the fee that must be paid to the party who lent the money).
Debt puts a constant demand on cash flow. That’s because you are required to repay the loan through monthly installments. Whether your business is having a good month or a not-so-good month, you must direct the funds to the lender or face the possibility of default. If you default, the lender has the right to foreclose on the mortgage and take whatever assets are needed to pay the debt in full.
OPM Impact on the Balance Sheet
The act of borrowing forces a double entry on a company’s balance sheet. Cash acquired under the loan becomes a “Cash” Asset on the books. However, a Compensating Liability must also appear because that money is not yours and must be paid back.
This is an important distinction because one of the ratios used to assess a company’s financial health is the debt-to-equity ratio. This ratio is calculated by first taking the value of a company’s Assets and subtracting its Liabilities. The rest is the assets of the company. Then, the value of the Liability is divided by the value of the Equity to determine the ratio. The higher the ratio number, the greater the risk that the company will be unable to meet its loan repayment obligations.
This ratio can affect the ability to borrow more money. It can also affect the willingness of suppliers to extend payment terms to your company. A highly leveraged company can be a poor credit risk that can cause vendors to demand cash payment for merchandise.
starting the company
Bootstrapping does not have the negative potential of borrowing. When you start up, you use existing company resources to fuel growth. This leverage involves understanding all the assets your company has and how to capitalize on them.
For companies with business-to-business (B2B) and/or business-to-government (B2Gvt) transactions, one of the best assets to leverage is their accounts receivable. Accounts Receivable (A/R) is the volume of money owed to you for the product delivered and/or the service rendered. It is a debt owed to you by another business or government agency.
Unfortunately, you can’t spend A/R. That money is not in your bank and cannot be used to pay the payroll, buy material or pay taxes. However, you can turn that A/R into cash without putting pressure on your customers to change their payment terms. The solution is to factor the invoices. “Invoice factoring” is the process of selling individual outstanding invoices for cash. It is a transaction that remains exclusively on the Assets side of the ledger as it converts A/R to Cash. In an invoice factoring transaction, you are not borrowing money; you are selling an Asset. Therefore, there is no Liability entry on your books.
Under what circumstances can factoring be used?
The use of Invoice Factoring is a right granted to a business under Article 9 of the Uniform Commercial Code. A company can “assign” the right to payment to a third party, a factoring company. There are very, very few situations where your right to assign does not apply. This means that any B2B or B2Gvt company can use invoice factoring as a means of solving a cash flow problem.
What financial institutions offer invoice factoring?
While some larger banks have departments that do true invoice factoring, most do not. One reason is that, in general, the underwriting criteria for invoice factoring differs from that of a traditional commercial loan. But because banks are regulated by the Federal Reserve, those with invoice factoring departments will generally apply the same underwriting criteria for both loans and factoring. This means that they will take a very close look at the personal credit and business credit of those who apply for a factoring facility. If those scores are not good, the application will be rejected.
Independent financial companies have greater leeway. Your main consideration is the solvency of your customer, the entity obligated to pay your invoice. If your business credit rating is good, the probability of winning a factoring facility is very high. Your business credit and/or personal credit score will have little impact on the decision to finance.
Summary
When faced with a cash flow problem, most business owners impulsively seek to borrow money. This is a viable route, but it is important to understand the potential challenges:
- Add a Liability to your Balance
- Affects your credit rating
- Increase your debt to equity ratio
- Places an additional monthly demand on cash flow
- Automatically creates the possibility of default and foreclosure
Bootstrapping and the use of Invoice Factoring is a reasonable alternative. It offers a fast and efficient way for a company to use its existing resources to solve a problem. It is inexpensive and, by law, universally applicable. Used correctly, it can help a business survive in tough times and thrive when times are good.