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1099-MISC Forms For Independent Contractors for 2005
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Accounts Receivable Factoring - A Viable Cash-flow Solution for Small and Medium-Sized Enterprises
The pace of change in today's business environment is inarguably
staggering. Growth of e-commerce; changes to business
structures; evolving relationships; changes to funding
arrangements; access to capital and its sources. All occurring
at increasingly exponential rates. Fast. The fact that there is
more computing power in the average notebook computer today than
it took to put a man on the moon should illustrate how fast
things change, and whether in senior management or a business
owner you need to keep pace.
In particular, you must stay abreast of changes in your
competitive environment, and remain fully apprised of mechanisms
that will enable a response fast enough to keep you in the game.
This article will look at one of those mechanisms, access to
capital and through that, free cash flow. In doing so we'll use
an intuitive framework, peppered with some economics. Why?
Intuitive analysis is ideal for answering specific questions; in
this case 'What will best enable my firm to manage rapid changes
to competitive economic conditions and stay in the game?' And
I'll use economics because of Steven Levitt, America's most
outstanding economist under-40, who along with Stephen Dubner
considers that 'if morality represents how we would like the
world to work, then economics represents how it actually does
work.'
By speaking to specific anchor points, strategic issues
affecting the access to capital problem can be explored and
initiatives developed to allow a timely solution. In short, it's
the fastest and most accurate way to answer the question you
face, because it's easier to understand and doesn't get bogged
down in extraneous, unnecessary analysis.
One of the anchor points in contemporary business is access to
capital, especially when it helps maintain free cash-flow. In
many respects they are one and the same thing, the difference
merely being access to capital is a necessary precursor to free
cash flow (you can't use it until you have it). And everyone
needs it. Payroll, materials, overhead, and debtors taking
anywhere from 45 to 120 days to settle their accounts, using
your firm as a surrogate line of credit.
Access to capital becomes an even larger issue in the business
environment described earlier, where speed to market and the
ability to 'tool-up' (increase production) are crucial to
meeting ever shrinking delivery timelines. Many of us have
experienced the elation of being awarded a large tender,
something that will fill the order book for the next six months,
immediately followed by the hangover that comes with the
realization that the firm will struggle to fund the project
based on existing and forecast cash flow.
Small-to-medium enterprises encounter particular problems when
it comes to cash flow and capital access to fund growing
operations, to the point where lack of access is an issue that
can threaten continuing operations, even in a rising market.
Balance sheets take time to build, and it is against this
security that banks will lend.
Developing initiatives to tackle this problem involves looking
at some existing options and making a comparison, arriving at a
decision that best enables a solution to the problem at hand. In
this instance, a comparison of bank funding against invoice
factoring provides insight into possible solutions for the
capital access / cash flow problem.
Everyday economics can inform this comparison, particularly the
study of incentives - how people get what they want, or need,
especially when other people want or need the same thing. Let's
start with banks.
Bank lending requirements are invasive and restrictive. They
often engender a feeling that you have to 'bare all' to borrow a
nickel. They would naturally dispute this claim, but let's
return to the incentives - what is their incentive for lending
you money? To earn a return off your efforts. Certainly nothing
short of this, and these days they also use lending as a lever
to win the biggest 'share of your wallet' from their rivals,
trying to have you as a customer for life, 'growing with you and
your business.' When you add the fact that a surplus of people
requiring credit exist in the market, they can afford to be
choosy and do the economically rational thing - be risk averse.
Risk aversion drives the mortgage a bank puts on your house to
ensure they get paid, and is what drives them to lend against
strong balance sheets. They look at balance sheets in an
accounting fashion, weighing up tangible, realizable, liquid
assets like cash and real property, apply a formula and lend in
accordance with how the result stack up against their risk
matrix. Your continuing success is of interest to them only to
the extent that it enables you to service (and ultimately repay)
your debt, generating an ongoing margin on their investment.
An overly simplistic description, the point being to illustrate
that all of this takes time, and is structured around heavy
regulation and evaluation constraints. Lots of time, and lots
of
influential rules. First, for you to build your balance sheet,
and second, to get it appraised to a point where your banker
might open or extend your credit facility. During that time, the
window of opportunity to fund that large project, manufacturing
expansion, or operations in a rising market quickly passes,
leaving you out of pocket your application fee and if
successful, servicing an even larger debt you might not need.
Turning to invoice factors, the incentives might seem the same,
but how they view obtaining their return is slightly different.
While banks rely on their acumen in accurately predicting your
ability to repay a debt, invoice factors rely on their skills in
accurately assessing the ability of your customer base to pay
you. A lower perceived risk aversion with invoice factors plays
a small part, but it is how the factor views the overall
situation that is different from traditional lending. To begin
with, factors recognize your accounts receivables as assets,
just like the bank. The difference is that an invoice factor
considers your receivables a quickly realizable asset, and is
prepared to purchase the rights (and risks) of collecting your
outstanding invoices.
Put another way, in economic terms the invoice factor recognizes
your receivables as assets with a future value in cash flow
terms, and provided their assessment of your customers is
favorable, they are prepared to effectively 'provide a market'
for those assets. This 'market' closes with your transaction
selling them the invoice however; there is no secondary market
like junk bonds or other derivatives.
Access to capital through factors is more expensive than
traditional lending, and this is due to the risk premium
attached not to you, but your customer base. This is not
surprising, and you and I would probably do the same. Returning
again to economics and our study of incentives, a rational
person requires a premium for every extra unit of risk they take
on. A bigger incentive for a perceived higher risk. In the case
of factoring, the premium is higher than equivalent bank lending
rates, as the risks are considered slightly higher when the
security is not real property, rather a first position claim
over all of your receivables. Your risk exposure is lower than
collecting the receivables yourself (invoice factors are very
good at mercantile operations) - the higher fee charged by the
factor compared to the bank is simply the premium you must pay
to lower that exposure.
The difference that factors provide is speed of access to
capital, and what happens when you default. Default on the bank
loan, you can lose your business, even the family home.
Factoring is not quite as drastic, although the sums of money
involved are invariably smaller. There are two types of
factoring products available, recourse and non-recourse, and
again, the difference comes down to assumption of risk, and the
premium asked to assume the risk of non-payment on an invoice.
With recourse factoring, you remain liable for non-payment by
your customer, and with non-recourse, the factor assumes the
risk up to a point, and at a higher premium.
In summary, there are merits and pitfalls in both traditional
lending and factoring. These are volatile economic times, and
having been burnt a number of times during boom times of the
previous two decades, banks are far more risk averse, holding
tight reign on their credit standards. So in light of this
information, we return to our problem, looking to answer the
question: 'Which of these approaches best delivers the
flexibility I require to allow me the opportunity to prosper in
a fast-changing business environment?'
For many businesses, the answer lies with invoice factoring,
which delivers in excess of $1 trillion in credit across the
continental United States. As with all business situations there
are caveats, or described another way, arrangements that if not
continually monitored can become a comfortable security blanket
that might actually be slowly suffocating you.
It is easy to become accustomed to continuing access to cash
flow through factoring. It is also easy to feel at ease knowing
you are backed by a massive publicly traded institution like
your bank. Management and owners of Small and Medium-Sized
Enterprises should continually remind themselves that the study
of incentives works for them too. Constant review of your
capital funding and cash flow arrangements is essential to
ensure that the deal you end up with is the best for your firm,
and not others. It's all about getting what you want, or need,
especially when other people want or need the same thing.
About the author:
David Springer is a consultant for Sovereign Funding Group.
Sovereign Funding Group is an experienced, reputable company
that offers convenient, no-risk services to help you with the
selling of your deferred payments and business financing
including accounts
receivable factoring.
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