Are you concerned about the lack of available business credit? Are you tired of seeing your inventory and receivable financing costs increase? Not sure how your small business will meet payroll or meet its day to day operating expenses? Well, you’re not alone. Easy business credit is a thing of the past, at least until this economy picks up. If your small business is in this situation and you need financing, don’t despair. There are solutions.
It starts with your willingness to investigate alternative financing options. Don't be intimidated by using non-conventional financing and business credit. They can work and work extremely well, provided you take the time to understand their pros and cons. Like anything in business, there is good and bad when it comes to alternate financing. If you've decided to go another route than using conventional bank loans and credit lines, then this might help guide you along.
Before going any further, understand that a number of small businesses are in the same boat. Most businesses, regardless of their size, need business credit lines and loans to finance their day-to-day operations. Whether it’s purchasing inventory, paying employees or keeping the lights on, most companies use credit lines to keep their business chugging along. Therefore, don’t view this situation negatively. It’s simply a function of the times. A number of companies are having issues given the current state of the economy. One customer is late paying and the rest follow suit. So, what are these options for small business financing?
Understanding Your Factoring Options
There are essentially two options your small business has when it comes to emergency financing. One is to draw cash from your unpaid customer invoices, called “receivables factoring”, and the other is to draw upon the value of those purchase orders placed by your customers, referred to as “purchase order factoring”. Companies that allow you to draw cash for invoices and purchase orders, are called “factors”.
Factors allow your small business to use your unpaid customer invoices, or your purchase orders, as a form of collateral. These companies will allow your small business to draw upon the value of your receivables and purchase orders. First, we’ll look at receivables factoring. Afterwards, we’ll review the purchase order factoring option.
The table and video above are taken from the post: Sample Receivable Factoring Excel Sheet: Effective Rates & Interest Rates
1. Receivables Factoring – Recourse & Non-Recourse
Your customer’s unpaid invoice, or “receivable”, has a monetary value. Factors will allow your business to draw anywhere from 80% to 90% of the receivable’s value. The cash is made available fairly quickly – within 24hrs. Factors then proceed to collect on your company’s receivable. Once they collect from your customer, they then return the remaining portion (20% / 10%) back to your small business, minus their fee for the transaction. There are two options when considering receivables factoring.
- Recourse Factoring
If you’re fairly certain your customer will pay the receivable, then it might be in your company’s best interest to choose the recourse factoring option. In this case, your small business is assuming the liability for the receivable. This means your company will be able to draw a larger payout from the factor, somewhere near that previously mentioned 90% of the receivable’s value. In addition, your company’s fee for the transaction will likely be lower. This is because your business is assuming all the risk. If the customer doesn’t pay the receivable, then your business is liable.
- Non-Recourse Factoring
If you’re concerned about your customer’s ability to pay the receivable, then it might be worthwhile to choose the non-recourse factoring option. In this case, it’s the factor that assumes all the risk and your initial payout is likely to be near that aforementioned 80% value. Because the factor is assuming all the risk, your transaction fees are likely to be higher. However, it's important to note that non-recourse factoring isn't as available as it once was. This is because the finance company must purchase insurance in order to cover the costs of bankruptcy, should the customer be unable to cover their invoice.
The Good & Bad of Receivables Factoring
There are some inherent benefits to receivables factoring. First, it helps to iron out those periods where cash flow is a concern. Second, it allows companies to break away from customers they are no longer interested in servicing. Third, in a number of cases, the fees for receivables factoring is extremely competitive when compared with the interest rates charged on bank loans and business credit lines. Finally, factoring isn't a loan and therefore won't appear as a liability on your company's balance sheet.
As with everything, there is both good and bad. One of the issues with receivables factoring is that the factor collects directly from your customer. If your small business wants to end a customer relationship, then using a factor may be acceptable. However, if your customer relationships are important, it’s probably best to discuss the situation with your customer first. Put yourself in your customer’s shoes. From your customer’s viewpoint, it can be a bit unnerving to be asked to pay a factor when they’ve always paid their bills before. Make sure to discuss this situation with your customer before hand.
2. Purchase Order Factoring
In some cases, just invoicing the customer may be your company’s biggest concern. Sometimes companies need financing in order to fulfill their customer’s purchase orders. This is not at all uncommon in large scale projects where lead times for integration and completion can cause numerous financing issues. In this case, your company has received a purchase order but lacks the financing to make the product. This is where your business would then use the purchase order factoring option.
With purchase order factoring, the factor will lend your business money based on the purchase order’s full value. Much like receivables factoring, your business will be able to draw upon a percentage of the order’s value –near that aforementioned 80% to 90%. Again, the cash would be made available rather quickly, and your business would be able to complete the order. Much like receivables factoring, the factor would collect directly from your customer.
When it comes to small business financing, and your options are closed to bank loans and credit lines, take the opportunity to investigate factoring. A number of businesses make factoring their preferred method of emergency financing. It’s fast, and relatively easy. Just be sure to manage your customer's expectations and discuss it with them first. This should never come as a surprise to them.
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