To generate working capital or to meet specific short-term cash needs, small businesses may use certain short-term assets as collateral for commercial loans.
The most common types of asset-based financing include:
- Accounts receivable financing uses receivables as collateral. As the business collects the receivables, the proceeds are used to repay the loan or line of credit.
- Inventory financing is a similar type of loan, using inventory as collateral.
- Factoring is a process whereby accounts receivable are actually sold to a third party (the factor) for a discount price, after which the factor takes on the job of collections.
Exploring accounts receivable financing
Accounts receivable financing is a type of secured loan in which a business’s accounts receivable are pledged as collateral in exchange for cash. The loan is repaid within a specified short-term period as the receivables are collected.
Accounts receivable financing is most often used by businesses facing short-term cash-flow problems. The major source of accounts receivable financing for small businesses is commercial finance companies, although banks will also consider receivables as security for a business loan.
Accounts receivable are typically aged by the borrower before a value is assigned to them. The older the account, the less value it has.Example
Financiers often lend approximately 75 percent of the face value of accounts less than 30 days old. Some lenders don't pay attention to the age of the accounts until they are outstanding for over 90 days, and then they may refuse to finance them. Other lenders apply a graduated scale to value the accounts so that, for instance, accounts that are from 31 to 60 days old may have a loan-to-value ratio of only 60 percent, and accounts from 61-90 days old are only 30 percent. Delinquencies in the accounts and the overall creditworthiness of the account debtors may also affect the loan-to-value ratio.
A monthly interest rate on accounts receivable is calculated by applying a daily percentage rate to the receivables outstanding each day (the less the outstanding receivables, the lower the interest charge). Defaulting on your payment can result in the financier seizing the pledged accounts receivable.
Some states require notice to the business's debtors that their debt has been pledged as loan security. In states that do not have this requirement, some businesses do not notify their customers because the businesses fear that customers might perceive this method of financing as a sign of financial instability.
Inventory financing and factoring
Inventory financing is similar to accounts receivable financing covered in the previous article, except your business' current inventory is used as collateral for the secured loan.
You can anticipate a very conservative valuation of your inventory and a maximum loan amount that is somewhat less than 100 percent of the lender's valuation figure. Average lender discounting would allow lending of up to 60 percent to 80 percent of the value of your ready-to-go retail inventory. A manufacturer's inventory, consisting of component parts and other unfinished materials, might be only 30 percent. The key factor is the merchantability of the inventory—how quickly and for how much money could the inventory be sold.
The loans are typically short-term and the interest rates are similar to those for accounts receivable lending. The most common use of inventory financing is for the purchase of new inventory, especially when an upcoming season requires that you keep additional inventory in stock.
Factoring is simply the sale of accounts receivable. By selling your invoices for future payment, you generate cash sooner than if you collected the money on your own. The factor company that purchases your receivables takes title to the invoices and collects them when they are due. That company also assumes responsibility for all of the costs, as well as the hard work and hassle that comes with customer debt collection.
Finding companies to purchase receivables
Commercial finance companies, certain banks, and a variety of different types of financial companies will (perhaps even gladly) purchase your receivables.
For businesses with relatively small monthly amounts of receivables (e.g., fewer than $10,000), you might have to expend a fair amount of effort to locate a factoring company willing to purchase those receivables. Searching Google or your local telephone book may reveal factoring "brokers" that can assist you in locating suitable factor companies.
Most commonly, factoring is used by rapidly growing businesses ($125,000 to $10,000,000 in annual sales) that face temporary cash flow problems. Except in certain industries, such as the garment industry, factoring is not used on a long-term basis.
Is factoring right for your business?
The biggest downside to factoring, as you've probably already guessed, is that it's not cheap.
In order to make a profit, the factoring company will discount the cash price of your accounts receivable. Your final cost will nearly always exceed the amount paid as an interest rate on a short-term commercial loan for an equal amount. Moreover, because factoring requires accounts receivable, it is usually limited to existing businesses.
Weighing the advantages of factoring
Although factoring isn't cheap and is limited to existing businesses, it does have its perks:
- Quick cash. You can receive quick payment in cash after the time of shipment, delivery, and invoicing a customer. This immediate payment for invoices nearly eliminates the sale-to-collection business cycle and allows businesses caught in a cash crunch to obtain fast relief. If a relationship with a factor already exists, turnaround on the sale of receivables should take only about 24 hours. When making a first-time purchase of invoices from a business, factors typically take one to two weeks to check the credit ratings of the customers and communicate a discount price.
- No debt. Factoring is a sale of assets (invoices), not a loan. For businesses that either cannot qualify for traditional debt financing or that simply do not want to incur more debt, factoring is good alternative means of financing.
- Eliminates collections. Most factoring is called "nonrecourse," meaning that the factoring company purchases all rights in the invoices and the seller has no responsibilities for collection. The factor's anticipated cost and time in making collections is computed into the discounted purchase price of the receivables. In some states, however, "recourse" factoring is also permitted. In recourse factoring, you are secondarily liable for any invoices not collected. The factor company undertakes debt collection, but you remain ultimately responsible to repay any portion of the cash price attributable to an account that went uncollected.
Considering the disadvantages of factoring
While factoring can ease a cash crunch, it may not be the best option to your cash flow issues:
- Cost. Traditional loans will typically be less expensive than the costs of factoring. The upfront cash price for accounts receivable is typically 70 percent to 90 percent of face value, depending upon the credit history of the customers and the nature of your business. The initial price is treated as a cash advance and you typically receive an additional portion of the face value when (and if) the accounts are collected. Your final price is usually between 90 percent to 95 percent of the original invoice amount. The longer the invoice period, the higher the rate. Most factors will not take invoices with longer than 90-day payment periods. In addition, the credit history of the customers can affect your final costs.
- Possible harm to customer relations. Collection actions taken by the factoring company may endanger an ongoing business relationship with one of your customers. In a small business, there may be circumstances in which you would compromise a debt, extend payment deadlines to a preferred customer, or employ a more lenient collection approach for a specific customer. A factoring company has little interest in preserving your future relationship with the debtor and some companies may be overzealous in collecting receivables.
Factoring agreements can be quite flexible, and you should always negotiate for the best terms possible. Renegotiation for a lower discount percentage is common in ongoing factor relationships. Yet the most negotiable charges are often not the initial discount percentage, but other additional charges (such as a fee for expedited wiring of your cash price or an initial user fee) assessed by most factor companies.
Leasing as a financing tool
Leasing companies, as well as banks and some suppliers and vendors, will rent equipment and other business assets to small businesses. Some manufacturers have leasing agents who may be able to arrange lease terms or a credit arrangement with the manufacturer, a subsidiary company, or a specific lessor.
Leasing assets, rather than purchasing them, is a form of financing because it avoids the large down payment frequently required for asset purchases and it frees up funds for other business expenditures.
However, you should be aware that leasing from conventional lenders may be difficult for startup businesses because traditional lenders require an operating history from prospective lessees.
Weighing the advantages of leasing
Much like the age-old argument of leasing or buying a car, opting not to buy does have its advantages:
- Free up cash. Many leases require little or no down payment. Leasing thereby allows you to direct cash toward other business expenses and investments. An improved cash position can also help your ongoing ability to obtain additional debt.
- Reduce debt on your financial statements. In a straightforward operating lease—in which you rent assets for a set time period without an ownership interest—neither the leased asset nor the cost of leasing appears on a balance sheet. Cash flow and expense-related financial statements will show only lease amounts as they come due. The relative absence of business debt will improve your chances for conventional loans.
- Enjoy more flexibility for equipment changes and upgrades. For businesses in which rapid technology changes or new equipment is common, leasing allows you to minimize the costs of purchasing equipment that is quickly antiquated. Many leasing companies also provide for lease upgrade options or termination fees. In addition, an option to purchase a leased asset is usually available if you want to buy the asset at the end of the lease term.
- Reduce tax liability. Leasing costs are deductible expenses that immediately reduce taxable income. You should compare the benefits of a lease deduction to the depreciation deduction you would obtain if you purchased the asset.
- Receive assistance from your landlord. If you are willing to enter into a long-term real estate lease for office or plant space, the landlord may be willing to finance certain improvements to the property that is necessary for your business. You can pay for these improvements through added rent over the period of the lease. This arrangement saves up-front cash and equity and does not impair your financial ratios for another financing.
Before diving headfirst into leasing, consider our discussion of the several disadvantages of leasing.
Capitalizing on the increasing popularity of leasing
Because more businesses are using leases, greater creativity in lease terms and purposes are becoming available. Leases can be drafted so that they resemble a long-term purchase of capital equipment.
The term of the lease approximates the expected useful life of the asset and the total of lease payments is keyed to the underlying cost of the asset. The lessee pays insurance and taxes on the asset. The lessee may either be required to purchase the asset at the end of the lease, or a purchase option may be available at the end of the lease or for a stated price during the term of the lease. A service contract can usually be purchased for an additional charge.
As your ownership options/rights are increased in a lease agreement, your financial statements may have to show the lease as an asset purchase, with an accompanying listing of the asset and a liability for the amount of the "loan." These changes will negatively affect your debt/equity ratios and your net income.
Exploring sale and leaseback options
A derivative form of lease financing, this type of arrangement requires the borrower to sell valuable, fixed assets like equipment or facilities to a financier who then leases the asset back to the seller. The sale performs three important functions:
- Generating cash to the small business for short-term needs
- Allowing continued use of the asset
- Creating a tax deduction for rental expense
A purchase option at the end of the lease period allows the original owner to reacquire title to the asset at a later date.
Trade credit and insurance loans
When most of us think of places to obtain credit, it usually boils down to two groups: personal contacts willing to invest in us or businesses designed to provide credit.
But two of the most obvious sources for financing often slip by unnoticed. Your suppliers and your customers represent possible sources of financing through a variety of credit and pricing options.
Financing through trade credit
"Trade credit" is the generic term for a buyer's (your business) purchase of supplies or goods from a seller (supplier) who finances the purchase by delaying the date at which the price is due, or allowing installment payments.
Vendors and suppliers are often willing to sell on credit. Many startup and growing businesses rely on this working capital financing. Suppliers, in turn, know that most small businesses rely primarily upon a limited number of suppliers. And, generally speaking, small businesses typically represent relatively small order risks. As long as the supplier keeps a tight rein on credit terms and receivables, most small businesses are a worthwhile gamble for future business.
Finding a trade credit provider
If your business is a startup, you may benefit from shopping for prospective suppliers as soon as the entrepreneur has a business location picked out. Many new businesses rely heavily upon a single supplier with whom they can reach a long-term understanding regarding credit purchases. Present your proposal to several possible suppliers, taking care to outline how much inventory you need to get started and how much you will buy from the supplier in the future.
Expect the supplier to demand a priority security interest in all goods provided to you on credit. You may also have to personally guarantee some of the purchase price, at least for initial inventory. The more business you do with a particular seller, the better your negotiating position for arranging additional credit purchases.
When managing the amount of trade credit and other debt your business assumes, the critical feature is not the total amount of debt, but rather the ability of your business to make payments from its cash flow. The duration of the pay period and the repayment amounts, in relation to incoming cash sources, are most important. Realistic cash flow projections and a strong cash flow history are consequently the primary interest of trade creditors.
Weighing the advantages of trade credit
Letting your supplies provide some of your financing can be a beautiful thing. The major advantages of trade credit include:
- Easy availability. Many suppliers grant trade credit to qualified small business owners.
- Amortized payments. Spread your payments over several months or years.
- Minimal down payments. In many cases, you can even negotiate no down payment, and interest charges are assessed.
Trade credit takes a variety of forms that go by different names:
- Simple delay in payment for purchases
- Sales on consignment
- Equipment loans
- Different options to assist dealers in financing stock purchases.
For instance, a supplier might agree to a promotion plan that allows you to pay for specific items only as they are sold (supplier retains ownership of goods until paid for). This plan permits the supplier to continually monitor the mix of merchandise on your shelves and to adjust to changes in demand.
Understanding buying on consignment options
Buying on consignment doubles as an inventory financing option in some industries, such as retail print products, electronic consumer products or furniture.
A purchase on consignment means that you pay the supplier for goods only if, and when, they are sold. The supplier keeps the title to the goods and when they are sold, you retain a portion of the sale and return the balance to the supplier. There are no significant upfront costs and if you don't sell it, you simply have to return it to the supplier.
Considering the disadvantages of trade credit
The cost of trade credit you should be most concerned about is usually a higher purchase price.
Keep in mind that vendors often experience the same cash flow pressures as small businesses and many sellers offer cash discounts for immediate payment. By purchasing on credit, you forego the cash discount price and pay a higher relative price for your goods. It's a good idea to learn the rules of thumb on when to take a trade discount.
Financing through your insurance company
If you have substantial cash surrender value in a life insurance policy, you can usually borrow up to that amount from your insurer.
Ordinarily, you would borrow against the policy and then re-lend the money to your business at the same interest rate. The business can then take an interest deduction on the loan and you do not earn taxable interest income on the transaction.
How repaying your life insurance policy works
When you borrow against your own policy, you are not obligated to repay the loan principal, only to pay interest on the loan. Interest is typically due on an annual anniversary date.
Most policies will allow you to simply add the accumulated interest to the principal, as long as you have not already borrowed up the cash surrender value of the policy. The rate of interest charged depends upon when the policy was purchased; rates on older policies might be very favorable. Of course, borrowing against your own policy means the eventual death benefit of the policy will be diminished by the amount of the loan, plus the loss of interest.
Understanding the cost of borrowing from your life insurance policy
As a source for loans that are not secured by an existing policy, insurance companies are not usually viable sources of financing for small businesses. Although insurers actively seek investments for unused premium income, the companies tend to invest in larger, established businesses.
If you have available security, such as real estate, insurance companies may provide some limited possibilities. Generally, insurance companies make secured term loans and mortgage loans. If you borrow from an insurance company, you can expect terms and interest rates similar to those available from a commercial bank. Insurance companies can provide your business with a large amount of capital at market interest rates, but you must have assets sufficient to cover the debt, plus 20 percent to 30 percent extra.