Every business has one thing in common and that is the need for cash. Even charitable organizations need a steady and constant flow of donations in order to keep the lights burning. Cash flow is simply the grease that lubricates the machine and allows it to function properly, but when the machine runs dry it can slow down or grind to halt causing pain and misery for those working in it.
Shangri La for any business (and their bankers) is when cash flow becomes so predictable that the business seems to run itself and profits are at a level that supports the owner’s lifestyle well beyond his actual needs.
What about the company that is on a growth trajectory and is pouring every cent back into the company to support its growth and pursuit of new business? The orders are coming in at a faster and faster pace which should be a good thing and new customer relationships are being formed which should lead to a solid stream of new orders in the future. So what’s the problem you ask? The problem is when you get an order you have to purchase materials and pay people to fill the order. For example, it may take 14 days or longer from the time the order comes in until the product is shipped, and you have not yet received any payment from the customer. Once the product ships and the invoice is created, your customer has 30 days to make payment and in all this time you have not received a penny, yet you had to meet payroll 3 times, purchase materials, and pay for the other items necessary to run your business. So even though the growth seems great, you are feeling the cash flow crunch of keeping up with orders as they accelerate in number and perhaps even size.
Your banker hears your story and he gives you a line of credit that seems small but you’ll take it because you need every penny right now and you don’t want to upset a customer by turning them away or shipping late due to a cash flow issue. This line of credit gives you some temporary relief which you needed but you already see the trouble ahead if the growth continues. That’s right, you max out the credit line to get caught up and fill orders but can barely meet the minimum payments required by the bank.
But how can this be since the company is growing so much and revenues keep increasing? Well it all goes back to the fact that it takes you at least 45 days to get paid from the time the order comes in, and that is if all your customers are paying on time. With some quick analysis you may discover that your “turn” is something approaching 60 days or even beyond. Ask any of your employees if they would wait 60 days for a paycheck! (Actually, I take that back, do not ask since they may think something is wrong with the company and walk out.) For a mature company with a slow growth rate the waiting period is not a problem since they will simply access their line of credit and pay it down as their invoices are paid without the worry of unexpected or unpredictable orders. In addition they will also be taking advantage of quick pay discounts from their suppliers. Missing supplier discounts can be no small deal since I personally know of a distributor who takes the savings from quick pay discounts as his annual bonus since he sees it as a reflection of his good management. This amounts to a few hundred thousand dollars per year for this owner. Not to shabby for saving 2% from his suppliers on products that were already planned for purchase. For a growing company, missing the opportunity to save 2% from supplier can be very painful, as the need for cash increases with each new order yet you are still waiting for payment from previous orders and the line of credit at the bank is maxed out.
The bank really does not like this scenario because they view it as a management problem and therefore a risk issue. You have taken short term money (bank line of credit) and turned it into long term financing by maxing out your line with no real hope of paying it back or down anytime soon even if the bank has a clean-up provision, which would require you to pay the line off annually. The bad news is simply this: Banks don’t like you. Banks think you are too risky because with strong growth you might blow-up at any second. It’s as if bankers had a choice they would never board an airplane until it had leveled off at 30,000 feet and would parachute out before the initial decent thus avoiding the risks associated with fast acceleration at take-off and the possibility of a hard or crash landing. Of course this is hyperbole when I say they don’t like you when the reality is they simply just prefer to lend to mature companies. They understand your situation and know most companies have to go through growth cycles to reach maturity, they just don’t want to participate in the risk. Your banker is your friend he is just a friend that does not like you right now but you should continue to pursue a strong relationship with your banker since it can be so much more meaningful than just a service provider who makes loans.
So now what? You have orders piling up, a maxed out credit line, a banker who wants his money back and won’t lend more, discounts you are unable to take advantage of from suppliers, another payroll is due and the bank account is looking a little thin. Do not despair because you have the most important asset in the business world, and that of course is your customers and their orders that result in invoices. You are now a candidate for cash flow financing. In fact, you were a candidate before it got this serious, but this scenario helps illustrate the point. You have a growing asset on your balance sheet and that is your accounts receivable, but you cannot feed your family on invoices, only cash will solve that problem. So we need to liquidate your accounts receivable and move it to the cash column and one of the easiest ways to this is by selling them.
In today’s financial marketplace you have several choices when it comes to cash-flow financing. I have already touched on the most traditional form and that is a bank line of credit secured by your account receivables or in some cases it may be an unsecured line with only your signature to back it up. Next you have bank sponsored accounts receivable financing which will vary somewhat from bank to bank with most banks not offering this type of financing except through a third party partner. This could be a viable option for the business I have discussed here and it would look something like this:
Transaction sizes are typically: $10,000 – $5,000,000
Advances: up to 90% of eligible accounts receivable
Services (will vary): customer credit reviews both new and existing
Invoice processing and mailing
Management Reports provided to you
Fees: Typically 1-3% of the invoice depending on size and your average turn.
Operationally you generate one or more invoices and send them to the bank daily in batches and they fund your account at 90% of the total invoice amount within 24hours. Bam! Instead of waiting 30 or more days for your customer to make payment you receive 90% of your money immediately. You have just accelerated your cash flow to within 24 hours and can now use that money to make payroll, take advantage of supplier discounts, purchase inventory, and INCREASE SALES without fear of customer credit issues or late payments. Essentially what you have done is outsource your accounts receivable management process all while getting paid in 24 hours.
What happens to the other 10%? This money is usually held in reserve against any unpaid invoices. For example, if you have an outstanding invoice of $1000 that your customer fails to pay within 90-120 days, the bank will use the reserve to receive payment and then try to collect on the account. So the reserve protects both you and the bank by allowing the bank to get paid back and preventing you from having to write a check to the bank because one of your customers failed to pay their invoice.
There is a product called Business Manager that works in a similar fashion and is available in a few hundred community banks around the country. Business Manager is a program that allows community banks to purchase the accounts receivable of their commercial and industrial clients while monitoring the performance of those accounts. It is a powerful program for both banks and business with the funding percentage, fees and reserves typically about the same as in the previous example. For the sake of full disclosure, I used to work for the company that created the Business Manager program. I still think it is a great program, especially for small businesses because it allows you to maintain a bank relationship prior to reaching that mature cycle and graduating on to more traditional financing solutions all while receiving funding in 24hours and online access to your reports.
Next we have traditional factoring. This is where you sell your invoices to a funding source (the factor) at a discount in return for immediate cash. Advances are typically in the 70% to 95% range of eligible invoices and fees will vary. Often there is no reserve account, instead the factor receives payment directly from your customer and pays you the 5% to 30% remaining minus the fees for the factor. Some factors place a stamp right on the invoice to show the change of address of where payments are to be made and others are able to do it silently by having an overall change of address and payment sent to a lock box. Most businesses prefer the factor to remain silent if possible, so you will want to check with the individual company. In addition, factors can provide funding to companies in the start-up stage to $100,000,000 in sales or more. This is because they are not concerned about your credit, but that of your customers. They will also want invoices that are verifiable and to know that you and your team are solid managers and experienced in your industry. In fact your company may be in a turn-around situation or bankruptcy and a factor may still provide funding because they are looking at your customer, not you.
Besides providing funding, a factoring company can also become your outsourced credit department. They will check customer credit quality; set customer credit limits; and provide daily monitoring of credit accounts. In many, if not most cases, today you will have real time access to reports such as accounts receivable aging, collection, and reserve reports. This gives you the ability to monitor your invoices and the average turn which should be decreasing at this point. The factor will also provide collection services and these will vary from company to company with some allowing for customization of the collections process.
The common thread between the different programs available is the conversion of your account receivables to cash by a funding source, whether it’s a bank or private entity. Check the exact terms and fees and be sure to be aware of what your responsibilities will be to the funding source. Cash flow financing may provide the needed solution for growing companies or companies that need a cash injection to make it through a turn-around.