Using Other People’s Money: Business Financing Solutions
Posted on September 26, 2013 in Asset Based Finance
Think back to when you first started your business. You understood that keeping your personal finances separate from your new venture was critical: You simply could not afford to be personally liable for any losses. This is the perfect example of financing a business using other people's money. Unfortunately, companies tend to get away from this philosophy. They choose to stick with the devil they know by financing their operations through banks and credit unions. However, things are changing: Asset-based lending is quickly establishing itself as a viable alternative to conventional financing. So what are some of the most common asset-based lending options?
Understanding Asset-Based Financing and Credit
The most common asset-based lending option is receivables factoring. This solution allows companies to use their receivables in order to secure an upfront cash advance. Instead of waiting for payment, your company simply exchanges its receivable for cash with a financing company. There is also purchase order financing. With this option your credit line is established based on the value of existing contracts, long-term agreements and customer purchase orders. Finally, there's inventory financing. This asset-based lending option involves setting up a credit line based on the value of a company's inventory. The inventory is used as collateral against the loan.
Each of these aforementioned solutions allows companies to use their current assets in order to set up a renewable line of credit. Companies are able to assume total control of how and when they secure the vital capital needed to finance their operations. Understanding each option in detail will help you identify your ideal financing solution.
Receivables Factoring: Financing operations with your receivables isn't something new. It's a solution that has been around for thousands of years. It's an easy solution to use because its success is dependent upon the credit rating of the account debtor (your customer). This means that the emphasis for credit approval rests with your customer's credit rating. While your company's credit rating is important, it simply isn't the most important criteria for establishing the credit line.
The process with receivables factoring is fairly straightforward. Each time your company generates an invoice, you forward that invoice to the financing company for approval. They review the account debtor's credit rating, their credit history and their history of payments with your company. Once approved, your company is able to draw cash from your newly established credit line. Each new invoice you generate is then used to secure more working capital. In essence, you are securing payment for the receivable well in advance of waiting for your customer to pay.
One of the main benefits of receivables factoring is that it won't be shown as a loan on your balance sheet. Granted, it's similar to a loan, but it's more of an advance on your receivable's value. In addition, the costs of this financing option are very competitive when compared to financing with a bank. In the end, you are securing cash from a third-party financing company, one that won't ask you to wait 30, 60 or even 90 days before accessing the cash you need right now.
Purchase Order Financing: This financing option is similar to receivables factoring, but with one critical difference: Financing occurs from the moment your company receives a purchase order. Instead of waiting to generate an invoice, your company simply forwards your customer's purchase order to the financing company the moment it's received.
Much like receivables financing, your company's credit line is established after a review has been performed on the credit worthiness of the account debtor. As such, it's essential that the account debtor is approved well in advance of any order you receive. Purchase order financing allows you to prepay, or partially prepay, for all the raw materials, consumables, spare parts and finished goods needed to complete your customer's order.
In some arrangements, it's the financing company itself that pays your vendors on your company's behalf. In other cases, your company pays your vendors and uses the money as you see fit. Once your customer is invoiced for their order, the financing company takes over on receivables collection. Purchase order financing helps you finance existing orders, while also helping you to clear out any outstanding backlogs on sales.
Inventory Financing: Inventory financing is a short-term capital advance where a company's inventory is considered collateral for the credit line. That credit line is repaid as inventory is sold. Once the entire inventory is liquidated, the company is then able to secure an additional loan in order to replenish their inventory counts.
This financing method is a perfect fit for companies that have quick inventory turns on finished goods. Companies with long sales cycles, and infrequent demand, are not good candidates for this financing option as they are unable to remain within the established terms of the loan. After all, not selling the inventory makes it extremely difficult to repay the advance your company receives.
Only companies that provide tangible finished goods can use inventory financing. Service-related enterprises are unable to benefit from this financing option. In addition, the costs of inventory financing are typically higher than receivables factoring and purchase order financing. However, it's still a solid financing option for companies who must prepay or partially prepay orders with vendors.
Companies are turning to asset-based financing because of its ease-of-use. There are multiple options to use. All of them allow you to use the value of current assets in order to set up a renewable line of credit. This flexibility allows companies to combine existing financing with multiple alternative solutions. In the end, it's the ideal strategy to using other people's money for business financing.