My dad was a carpenter by trade, and we also had a small farming operation. I have many fond memories of my dad figuring numbers for jobs, supplies, measurements, plans, ratios, average daily gain, yields, and much more. Numbers like these are the vital statistics of a business. As a business owner, you need to know your numbers. One of the most important numbers you should know is working capital. What is it and how do you get it?
Working capital is the life blood of small business. If your business must wait for 30 days or more to get paid for work you have already done, then you are likely feeling the pinch of reduced working capital. In your business, sales, materials, labor, and overhead must continue even if cash is not pouring into your business every day. There is also the issue of being ready and able to strike when the iron is hot. If you are in an industry sector that is prone to rapid growth, without adequate working capital you can miss opportunities for growth.
Working capital is the difference between your current assets and current liabilities. It measures your liquidity and it’s therefore an indicator of the short-term financial health of your business. The problem with working capital is that not all forms of current assets have equal value. Sometimes your working capital is frozen in your inventory or accounts receivables, doing you little good if you need cash to cover operating expenses, make normal debt service, pay payroll, or payables. These demands on your cash will not wait.
One Option: Lines of Credit
One solution to cash flow problems is a line of credit provided by a bank. Because lines of credit are forms of debt, you must qualify for one. The irony is that a line of credit is easy to qualify for when you don’t need one, but difficult when you do. The process is time consuming, and seldom is the line large enough. A line of credit can make a bad situation worse by putting your business in a debt trap. If your line of credit grows faster than your inventory or receivables convert to cash, you’ll incur excess debt that compounds the very problem you were trying to solve in the first place. The reality is that lines of credit are debt instruments that further reduce true working capital. It’s important to keep in mind that access to cash through a line of credit it is not the same as having your own cash. Ultimately, it is your responsibility as the business owner to know how much cash your business needs and how much you can afford to pay back.
While lines of credit are among the cheapest forms of outside working capital, they are no bargain if you don’t use them properly. Astute financial managers that exercise discipline and maintain tight controls can make effective use of a line of credit. Where lines of credit are used to supplement cash flow, just be careful. If your company has a strong cash position, a short cash conversion cycle, and generally strong financials, a line of credit may provide a good solution for you.
Another Option: Merchant Cash Advance or Business Loan
A much faster way to get cash is through a merchant cash advance, sometimes simply known as a business loan. These products are offered by seemingly respectable companies, some of whom are publicly traded. Approval can often come within 24 hours and cash within 24-36 hours. However, this option is a trap. Many of these companies use various bait and switch tactics or other deceitful techniques to lure clients in. They may advertise low or no-interest loans in exchange for fees that can amount to effective rates of greater than 50%. These companies will want to review your bank statements and then will very quickly offer you funding which they can have in your account the same day or the next, and they won’t even require any collateral.
These deals will fund quickly and then they will begin to withdraw to receive their payback daily, often the next day. The daily withdrawal will seem much less painful than the full amount they will take from you monthly. We have seen deals like this offered to clients with fees in excess of a 70% effective interest rate. It is not uncommon for these companies to give you one smaller cash advance loan and then stack two or three more on afterwards because of your good payment history. They resort to this tactic, not because they couldn’t qualify you for more debt to start with, but because they didn’t want to scare you off with a larger payment. You should run from these predatory credit providers as fast as possible.
Yet Another Option: Factoring
Factoring is a type financing that alleviates cash flow problems that result from slow payment of invoices. Factoring, sometimes called Accounts Receivable (AR) financing, allows you to secure financing using the value of your invoices. Although not usually as fast to obtain as a merchant cash advance, factoring is usually faster than applying for a line of credit. A factor (the company providing you with cash) will purchase your receivables, usually with recourse. This means that if your client ends up not paying an invoice, then the factor will usually come back to you and have you pay back the uncollected amount. The good news about factoring is that it is an asset purchase which means that you are simply trading out a stale asset AR for a liquid one: cash, without incurring debt. Factoring does away with the debt trap concerns associated with lines of credit, because it only advances funds for work that you have completed. Because the factor is repaid as your invoices are paid, this type of financing is self-liquidating. There is no way you can draw more than what you have already billed out.
Factoring, however, is usually a more expensive option. A typical factoring agreement is “close ended”, meaning it has a pre-determined duration, usually a year. You are typically required to notify the factor in writing before the agreement expires it you want to terminate it. If you decide to terminate the agreement early, there are often fees owed to the factor for what it estimates you would have funded had you let the agreement run full term.
Your use of a factoring company is generally not transparent to your clients. For example, if you use a line of credit, your bank would not typically call your clients to say, “we are now financing your vendor, and you need to just send us what you owe them.” Factoring companies, however, sometimes call your clients and let them know that they now own your AR and that payment needs to go directly to the factor. Should your client’s payment drag out further than expected, they may get a collections call from your factor, which may create problems in your relationship with those clients. Customers sometimes have strong, negative reactions to these calls, and adopt a stance that if they hear from your factor about your invoices, they won’t use your business for future needs.
Factoring will typically involve a small initial fee. Then, as your invoices age past certain dates, you incur additional fees. These fees can vary significantly on each invoice, making it hard to know your all-in cost. Because a Factor is not a bank you will also usually pay wire fees to get funds into your operating account.
The Best Option: BusinessManager® Line
BusinessManager® is a working capital financing solution offered through many of our commercial bank partners. It is a cash management tool that brings the best of all the other options we’ve described. Like factoring, it is an asset purchase funding tool and therefore does not require a business owner to take on additional debt. Like a line of credit, BusinessManager® is transparent to your customer. The underwriting requirements are relaxed, and the funding process moves along quickly. BusinessManager® lines are typically approved at 1.5 times your average AR balance and are elastic in nature. This means, the capital it provides can grow with the funding needs of your business. While the rates are higher than a traditional line, they are cheaper than factoring.
This table summarizes the working capital options discussed in this article:
The team at Financial Consulting Inc. can help you make the right choice for your business to obtain working capital. With our extensive network of partners, we can simplify the process finding a trustworthy financial partner. Contact us to learn more!
BusinessManager® is a registered trademark of ProfitStarts® a division of Jack Henry & Associates, Inc. ®