Alternative financing options for small business

Mike Parrish

During my dozen-plus years in the alternative-financing industry, I've seen what I call the "David vs. Goliath" scenario so many times that I can usually spot it within two minutes of talking to a small business owner about their cash flow challenges. Here's an example of how it usually plays out:

A small tool manufacturer has struck pay dirt, landing a large contract to supply a big hardware chain with his implements. At first the owner (let's call him David) is thrilled. Later his excitement fades. The volume order is great. But he realises that the price of doing business with a big hardware chain (let's call it Goliath) means accepting its extended payment terms, which in this case are net-60 days from receipt of David's invoice. His cash flow will be hammered.

Cash is king in today's economic environment, and large corporations are sitting on piles of it. Still, they want more. And to get it, they're extending their payment terms to 60 and even 90 days. This is forcing many of their small vendors to scramble to finance, lengthening their internal cash flow cycles.

I recently talked with the owner of a small technology firm whose largest customer (representing 70 percent of his sales volume) is now stretching out payments well beyond the normal net-30 days. This, of course, is putting a severe strain on his cash flow. (Tech bellwethers Cisco and Dell announced last year that they would stretch their vendor payment terms to as long as four months.)

Risk-reward calculation

My David vs. Goliath scenario illustrates the risk-reward calculation small business owners must now often make when they have the opportunity to do business with a large customer. The boost in sales is great. But they have to be able to survive the cash flow lag created by the extended payment terms.

If they can't cover the lag with internally generated working capital, they need some kind of outside cash infusion. And with so many banks still operating under the tight credit procedures that they implemented in the wake of the financial crisis, more and more small businesses are turning to alternative-financing options.

Two options increasingly popular with small businesses are factoring and accounts receivable financing. These are both considered "alternative" financing tools because they fall outside the realm of traditional bank financing vehicles like term loans and lines of credit.

Factoring is the sale of a vendor's receivables to a commercial finance company (or "factor") at a discount. For example, suppose a vendor has just sent a $5,000 invoice to a large customer that pays in 45 to 60 days. Instead of waiting to get paid, the vendor could sell the invoice to a factor and have 80 percent of the invoice (or $4,000) in hand the next business day. The balance of the invoice, minus the factor's fee (typically 2 percent to 5 percent), is paid to the vendor when the factor collects the invoice.

The vendor typically decides which invoices to sell to the factor, which assumes management of the receivable until it's collected. This includes performing credit checks on the client, analysing credit reports, mailing invoices, and documenting payments. For more information on consumer credit checks click here >>

To obtain company financial information click here >>

Exponential business growth

Accounts receivable financing is a little different. It allows vendors to borrow up to 80 percent of the value of their qualified receivables (known as the borrowing base) on a revolving basis. It's similar to a revolving line of credit with a bank. But unlike a bank credit line, which is usually secured by hard assets such as equipment or real estate, the accounts receivable line is secured by the receivables themselves.

The beauty of an accounts receivable line of credit is that as sales grow so does the potential borrowing base and the vendor's access to capital, thus enabling exponential business growth. Every time a sale is made, the business can borrow more money, with interest charged only on the amount borrowed.

It's important to keep in mind that factoring and accounts receivable financing are usually not considered permanent sources of financing. Rather, they're designed to help companies weather temporary periods of financial instability or rapid growth, which can make them unattractive loan candidates for banks. After 12 to 18 months, these businesses may become bankable again and resume lending relationships with traditional banks.

For more information on trends in Australian business payments terms and its effect on business cash flow, see D&B's latest Trade payments analysis report >>

Mike Parrish is the southeast business-development officer with US firm the Commercial Finance Group, an asset-based lender.

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