Working capital: 2 great options to explore
Watch the Fridays With Vistage webinar: Working Capital for Growing Companies
It doesn’t matter how strong your product/idea/service is if you can’t obtain working capital.
And as many small business owners will tell you, lining up working capital can be about as likely as winning a one-on-one basketball game against LeBron James. For many businesses, conventional bank loans are out of the picture and even the more-palatable Small Business Administration-backed loans (SBA) are a stretch.
But that doesn’t mean you don’t have any options, especially if your business is otherwise viable.
Two potential options are factoring and purchase-order financing. Let’s take a look at both.
Factoring is an ancient method that’s also known as receivable financing. Basically, your company uses the money owed to it by customers as collateral for a loan agreement with a financial firm.
The risks associated with a tight cash flow are assumed by the financing company, which assumes the collection efforts. In exchange for that service, the financing company takes a small percentage off what it collects for you. That may amount to about 2 percent.
Of course, the financing company will have some parameters of its own. For example, the money must be owed from other businesses, not individuals. And the lender also will consider how credit-worthy the businesses that owe you money are.
That said, business can overcome that potential problem by picking and choosing which invoices it will sell to a factor. Like up every other financial decision, lining up a factoring arrangement requires plenty of due diligence. Also find out how long the company’s been in business and whether it specializes in particular areas, as some focus on a specific industry.
Purchase order financing
Also known as P.O. financing, purchase order financing is used to provide short-term capital that covers the cost of both manufacturing and shipping hard goods. This kind of arrangement is good for a company just getting started or is cash poor.
Let’s illustrate how the arrangement works.
Say there’s a small company that sells offbeat soft drinks – primarily through its own website. A large convenience store chain takes notice and tells the company it wants to put its drinks into all its East Coast stores as a test market; should the drinks prove popular, the chain says it will gradually expand to all its outlets nationwide.
That sounds great – until the business owners realize they won’t be able to fulfill the order unless their manufacturer rapidly increases production. And that’s troublesome because they don’t have the cash on hand to pay the manufacturer.
Enter purchase order financing.
The P.O. financing company pays the soda manufacturer directly. Once the drinks are shipped and the retailer receives an invoice, the financing company is paid by a factor, who assumes responsibility for the invoice.
Note that the lender will be checking the credit of the convenience store chain instead of the company actually producing the drinks. Should everything check out, chances are good the lender will agree to a deal.
Let’s put some sample numbers to the deal.
The chain wants 200,000 bottles of drinks at a wholesale cost of 75 cents apiece, with $1.50 as the retail price. Thus, the invoice would be for $150,000. Assume payment is due within 30 days of the products’ receipt. Considering that the cost to manufacture each drink is 25 cents, the small business would have to pay its supplier $50,000 60 days in advance.
The P.O. financer would pay the drink manufacturer the $50,000. After the product ships and is invoiced, a factor pays the financier $50,000, along with interest and fees.
At the same time, the original business will receive about 85 percent of the invoice (depending upon the arrangement terms), minus the amount paid to the P.O. financier. When the convenience store chain pays the invoice, the original business receives the remainder of its payment – after the factor’s fees are subtracted.
On first glance, it sounds complicated, but it’s really not. And given the lack of financing options fledgling companies often face, working with a P.O. financer – or a factor – may well be the only viable option.