Improve Cash Flow with Alternative Financing

The statistics may say that the U.S. economy is climbing out of the recession, but many owners of small and mid-size businesses will tell you they’re not seeing any recovery, at least not yet.

There are various reasons for this, but one is starting to stand out: a lack of cash flow caused by longer payment terms imposed by vendors. Of course, dealing with slow-paying customers is nothing new for many small businesses; however, the problem is exacerbated in today’s sluggish economy and tight credit environment.

This is frustrating for small businesses, given the fact that many big businesses have accumulated large cash reserves over the past couple of years by increasing their efficiencies and lowering their costs. Several high-profile corporations, including Dell, Cisco, and AB InBev, announced recently that they’re extending their payment terms to as long as four months.

So here’s the picture: Large corporations are sitting on piles of cash and are therefore more capable of paying promptly than ever before. But instead, they’re stretching out their payment terms even further. Meanwhile, many small businesses are struggling to stay afloat, or even grow, as they try to plug cash flow gaps while waiting for payments from their large customers.

How Alternative Financing Can Help

To cope with these kinds of cash flow challenges, more small and mid-size businesses are turning to alternative financing. These are creative financing solutions for companies that have a hard time qualifying for traditional bank loans and need a financial boost to help manage their cash flow cycle.

Startup businesses, companies experiencing rapid growth, and those with financial ratios that don’t meet a bank’s requirements are often good candidates for alternative financing, which usually takes one of the following three forms.

1. Factoring: In a factoring relationship, businesses sell their outstanding accounts receivable to a commercial finance company (or factor) at a discount, usually between 1.5 percent and 5.5 percent. The factoring company then becomes responsible for managing and collecting the receivable. A business usually gets 70 percent to 90 percent of the value of a receivable upfront when it sells to the factor, as well as the balance of the receivable (minus the discount, which is the factor’s fee) when the factor collects the receivable.

There are two main types of factoring: full-service and spot factoring. With full-service factoring, a business sells all of its receivables to the factor, which performs many of the services of a credit manager, including credit checks, credit report analysis, and invoice and payment mailing and documentation. With spot factoring, the business sells select receivables to the factor on a case-by-case basis without any volume commitments. Because it requires more extensive controls, spot factoring tends to be more expensive than full-service factoring. Full recourse, non-recourse, notification, and non-notification are other factoring variables.

2. Accounts receivable financing: Accounts receivable financing is more like a bank loan than factoring. Here, a business submits all of its receivables to a commercial finance company, which then establishes a borrowing base against which the business can borrow money. The receivables serve as collateral for the loan.

The borrowing base is usually 70 percent to 90 percent of the value of the qualified receivables. To be qualified, a receivable must be less than 90 days old and the underlying business must be deemed creditworthy by the finance company, among other criteria. The finance company will charge a collateral-management fee (usually 1 percent to 2 percent of the outstanding amount) and assess interest on the amount of money borrowed.

3. Asset-based lending: This is similar to accounts receivable financing, but in this case the loan is secured by business assets such as equipment, real estate, and inventory. The business manages and collects its own receivables, submitting a monthly aging report to the finance company. Interest is charged on the amount of money borrowed, and certain fees are also assessed by the finance company. As with all commercial lending, rates are negotiable. Lenders will look at your credit record, how long you've been in business, and whether your assets are liquid.

Overcoming Fears and Objections

Some businesses shy away from alternative financing vehicles, due either to a lack of knowledge or understanding of them or because they believe such financing vehicles are too expensive.

However, alternative financing is not hard to understand. An experienced alternative lender can clearly explain how these techniques work and the pros and cons they may offer your company. As for cost, it’s really a matter of perspective. You have to ask whether alternative financing is too expensive compared to the other options.

If you’re in danger of running out of cash while you wait to get paid by large customers and you don’t qualify for a bank loan or line of credit, then the alternative could be bankruptcy. So while factoring does tend to be more expensive than bank financing, if a bank isn’t an option for you, then you must compare the cost to possibly going out of business.

Most business failures occur because the company lacked working capital, not because it didn’t have a good product or service. Unfortunately, this problem is currently magnified for many small businesses dealing with ever-longer payment terms from their large customers. Alternative financing is one possible solution to this common cash flow problem.