Why Using Invoice Factoring Is a Smart Business Move

Many businesses struggle with having enough money on hand to meet financial obligations. This is the definition of a “Cash Flow” problem. To address this problem, companies generally take one of two approaches:

 

  1. Use other people’s money (OPM), i.e., borrow; or
  2. “Bootstrap” the business by using its own assets and financial resources.

 

Most business owners instinctively look to borrowing as the solution. This article discusses Bootstrapping as a viable alternative.

Other People’s Money

Using OPM involves either equity financing (selling away a piece of the business – and thus part of your autonomy) or debt financing (borrowing). This article focuses on debt financing.

“Debt” is the money owed to another person or institution. If used to address a Cash Flow problem it can be an albatross around the neck of a company. When a business “borrows” money (i.e., takes out a loan), it incurs a debt that must be repaid. The repayment includes both principle (the amount borrowed) and interest (the fee to be paid to the party that lent the money).

Debt puts a constant demand on cash flow. That’s because you are obligated to pay back the loan through monthly installments. Whether your business is having a good month or a not so good month you must direct funds to the lender or face the possibility of default. If you default, the lender has the right to foreclose and take whatever assets are necessary to pay the debt in full.

OPM’s Impact on the Balance Sheet

The act of borrowing forces a double entry on a company’s Balance Sheet. The cash acquired by virtue of the loan becomes a “Cash” Asset on the books. However, an offsetting Liability must also appear because that money is not yours and must be paid back.

This is an important distinction because one of the ratios used in assessing the financial health of a company is the Debt to Equity Ratio. This ratio is calculated by first taking the value of a company’s Assets and subtracting its Liabilities. The remainder is the company’s Equity. The Liability value is then divided by the Equity value to determine the ratio. The higher the ratio number the greater the risk that the company will not be able to meet its loan payment obligations.

This ratio can impact the ability to borrow more money. It can also impact the willingness of vendors to extend payment terms to your business. A highly leveraged company can be a poor credit risk which can cause vendors to demand cash payment for merchandise.

Bootstrapping the Company

Bootstrapping does not have the downside potential of borrowing. When bootstrapping you use the existing resources of the company to leverage growth. This leverage involves understanding all the assets your company has and how to capitalize on them.

For companies with business-to-business (B2B) and/or business-to-government (B2Gvt) transactions one of the best assets to leverage is its Accounts Receivable. Accounts Receivable (A/R) is the volume of money owed to you for product delivered and/or service rendered. It is a debt that another company or government agency owes to you.

Unfortunately, you can’t spend A/R. That money is not in your bank and can’t be used to meet payroll, buy material or pay taxes. You can, however, convert that A/R to cash without pressuring your customers to alter their payment terms. The solution is to factor the invoices. “Invoice Factoring” is the process of selling individual outstanding invoices for cash. It is a transaction that stays exclusively on the Asset side of the ledger in that it converts A/R to Cash. In an invoice factoring transaction you are not borrowing money; you are selling an Asset. Therefore there is no Liability entry on your books.

Under What Circumstances Can Factoring Be Used?

The utilization of Invoice Factoring is a right granted to a business by virtue of Article 9 of the Uniform Commercial Code. A business may “assign” the right to payment to a third party – a factoring company. There are very, very few situations where your right to assignment may not apply. This means that any B2B or B2Gvt enterprise can use Invoice Factoring as a means of resolving a Cash Flow challenge.

Which Financial Institutions Offer Invoice Factoring?

While a few larger banks have departments that do true Invoice Factoring, most do not. One reason is that, in general, the underwriting criteria for Invoice Factoring differ from that of a traditional business loan. But because banks are regulated by the Federal Reserve, those that do have Invoice Factoring Departments will typically apply the same underwriting criteria to both lending and factoring. This means they will look very closely at the personal credit and business credit of those applying for a factoring facility. If those scores are not good, the application will be declined.

Independent financing companies have greater leeway. Their primary consideration is the creditworthiness of your customer – the entity obligated to honor your invoice. If their commercial credit rating is good, the probability of winning a factoring facility is very high. Your company’s credit and/or your personal credit score will have little impact on the decision to fund.

Summary

When confronted with a cash flow problem, the majority of business owners impulsively look to borrow money. This is a viable route, but it important to understand the potential challenges:

 

  • It adds a Liability to your Balance Sheet
  • It affects your credit rating
  • It raises your Debt to Equity Ratio
  • It imposes an additional monthly demand on cash flow
  • It automatically creates the possibility of default and foreclosure

 

Bootstrapping and the use of Invoice Factoring is a reasonable alternative. It offers a quick and effective way for a company to use its existing resources to solve a problem. It is inexpensive, and, by law, universally applicable. Used correctly, it can help a company survive in difficult times and thrive when times are good.