Friday, November 27, 2009

How To Finance A Small Business Without Going Into Debt

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Unless your parents are wealthy, or you have a rich uncle or aunt from whom to borrow money, once you start a small business you will quickly find that you need more money than you have to keep your business going.

Many entrepreneurs seek financial help from their local banks. Those with good credit, go into debt using their homes as collateral for loans to finance their businesses. An alternative source of financing not often thought about that does not require going into debt is called ‘account receivable financing, or factoring’.
  • Account receivable financing is available only to businesses that have been in operation for at least a year, and have sold goods or services to customers on credit – usually on 30 – 90 days credit terms. The sum of the face value of the unpaid invoices is the ‘account receivable’: or said another way, money that the small business owner must wait 30 or more days to receive. 
  • Factoring enables a small business to receive immediate cash for its unpaid receivables by selling them to a factoring company. The factoring company pays cash for the receivables to the small business owner less a fee called a ‘discount’, as well as interest where applicable.
  • Factoring differs from a bank loan in 3 ways: emphasis is on the value of the receivables not on the credit worthiness of the company selling them. Factoring is not a loan, it's the buying of a financial asset. And unlike a bank loan, factoring involves 3 parties: the factor, the seller and the debtor.
  • Ownership of the receivables is transferred to the factoring company upon conclusion of the sale, indicating that the factor accepts all the rights and risks associated with the receivables. Usually the factor sends bills to the debtors and receives all payments. If the debtors are unable to make payment due to bankruptcy, the factor cannot seek payment from the seller where a ‘no recourse’ factoring was agreed to.
  • The cost of ‘no recourse’ factoring is higher because the factor assumes the entire risk of non-payment by the debtors. However, the seller can reduce his factoring cost by entering into a ‘recourse’ factoring agreement where in the event of non-payment the seller must buy back the bad invoices with good ones.
  • A factoring transaction has 3 major parts. The ‘advance’ is a percentage of the total receivables paid to the seller on submission of the application. The ‘reserve’ is the balance of the receivables held until the debtors make full payment. The ‘fee or discount’ is the cost of the transaction that is deducted from the reserve before final payment to the seller.
  • The factoring company may also charge the seller interest based on how long it must wait to be paid by the debtors. An estimate also made for the amount that may not be collected due to non-payment is added to the mix in determining the amount the seller will receive.
  • The objective of the factoring company, as all businesses have, is to make a profit; so it is vigilant in avoiding losses due to non-payment. Consequently, the factor thoroughly examines the credit worthiness of the debtors, buying only those invoices with a reasonable chance of been paid.
  • Factoring is a trade off between the return the seller hopes to receive from using immediate cash to pay suppliers, rent, meet payroll, expand production or boost sales promotion, and the cost of using the funds raised by factoring. Obviously, where the cost of using factoring is higher than the return on investing the funds, it is not a favorable trade off for the small business.
  • A small business may also use the funds from factoring as bridge financing while it waits for approval of venture capital, or a loan from a bank, as some of these financial transactions take weeks to release cash to the borrower. Usually, a factoring company will release cash to the seller within 48 hours.
  • The benefits of factoring is that many small businesses do not meet the financial requirements of traditional lending institutions, but have a roaster of financially strong customers that they can leveraged to get immediate access to cash without going into debt.
While factoring is an attractive alternative of raising operating capital, the costs associated with it may be higher than traditional loans, since the factor’s risk is higher, and has to provide others services including credit check and collection services as part of the total transactions.

Therefore, use factoring with prudence. Do you need cash immediately? Can you arrange credit terms with your creditors that allow you time to collect your receivables before paying them? Does the return on the funds raised by factoring justify its use? A small business consultant can provide answers to these questions. Be sure to talk to a consultant before signing a factoring agreement.  

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