Financing from Operations: Pay As You Go
Additional business financing doesn't have to come from outside lenders or traditional investors.
Asset-based financing, factoring and other forms of accounts receivable financing are commonly used to generate cash for a business using current hard assets, money owed to a company and even using future payments from customers as collateral to back up a business loan.
Asset-based financing is the simplest form of financing for your business. Let's look at a typical example of asset-based financing.
Your company owns a fleet of service vehicles that delivers services to your customer base. Indeed, as the company owner, you can use those expensive service panel trucks as loan collateral to secure business capital at the lowest possible rate because that loan is collateralized by your fleet of service vehicles.
Assets don't have to be common items, like service vehicles, however. Specialized equipment is used as collateral, but selling specialized, industry-specific equipment is more difficult than selling widely-used assets like vehicles or the real estate that houses your business.
Because of this, some banks and other lenders are less likely to consider collateralized loans backed by plastic extrusion equipment and, if they do, these lenders are likely to discount the true value of the equipment to offset the potential difficulty of selling highly-specialized tools and machinery. Let's face it - it's a lot easier to sell a panel truck than a plastic extruder.
Asset-based financing can be risky - an important point to keep in mind. If you pledge a piece of equipment that's vital to your business and you default on repayment of an asset-based loan, you may be out of business. Permanently!
Factoring is a generic term describing the practice of using accounts receivable to collateralize a loan. Customers owe you money but you need cash now. That's when factors can be very helpful.
Let's say you sold manufactured products to another business and extended credit, allowing the buyer of your products to pay your company within 60 days – “net 60" in business terms.
If you need money today - before the 60-day grace period ends - factoring enables you to borrow capital from a third-party using the invoice as collateral. You receive the cash you need today, and the factor/lender is repaid, with interest, when the invoice is paid by your B2B customer. The amount of interest, or the type of factor/lender you choose, is based on the length of time the account will be outstanding and the likelihood of that account being paid, whatever the time frame.
Factors want to be paid on time and they want a nice return on their investment, even when the investment is backed by monies owed to your business. Be prepared to pay interest, fees and other expenses when employing the services of a factor. It's not cheap money but it does even your business' cash flow.
For a larger percentage, or a higher interest rate, the factor may also assume responsibility for collecting outstanding receivables. However, these types of factors charge that higher rate to compensate for the administrative costs associated with collecting on your company's accounts - costs you won't incur, so you may actually save on collection costs using a factor to do the work for you.
The main advantage to factoring is that your business obtains immediate short-term cash without taking on short- or long-term debt, or diluting equity by offering an ownership stake to an investor in exchange for cash.
Factoring arrangements include:
- Advance factoring (also called discounting). Your receivables are purchased based on a credit and risk evaluation. Your company draws funds on invoices assigned to factors according to an agreed-upon advance rate, aka interest. Your company receives cash when goods are shipped, services are rendered and invoices generated. No "net 30" or "net 60." You get cash NOW - when you need it.
- Maturity factoring. Maturity factoring is similar to advance factoring, except your business receives funds based on the average maturity date of your company's monthly sales. In effect, you normalize (even out) cash flow while still maintaining an A-1 credit rating with your bank and other traditional lenders.
- Collection factoring. In effect, the factoring firm handles your accounts receivable process for a fee. The result is steady cash flow and improved receivables turnover, but you do incur costs for this service.
Another type of factoring is based on borrowing against future credit card sales.
Some lenders actually purchase a portion of your company's future credit card sales in exchange for cash today. In effect you "borrow" against future sales. An agreed-upon percentage of future sales is used to pay back the outstanding loan.
The amount of capital for which your company is eligible is based on past sales and future sales projections. The process of obtaining credit financing can take several months and often produces a hefty accounting bill for small business owners so be aware.
Your business has numerous assets, both physical and unrealized. Using existing assets to back a business loan is a great way to smooth out cash flow, to generate capital when it's needed and to maintain a quality credit rating.
Be sure to weigh all of your borrowing options before signing on the dotted line. Financing business growth through current operations is smart business and a good use of company assets. However, asset-based loans and factoring do add to the operational costs of doing business. Weigh the pros and cons carefully before you sell off part of your company's future.