Are
You Providing Interest-Free Financing to Your Customers?
Many businesses lose
money this way. We see this scenario
every day and in each situation the owners are shocked to find out
how much money they are really losing. As an example, consider company
that carries an average of $500,000 in receivables at any given
time. The company’s aging schedule indicates that most of
their customers pay in 30 to 45 days, with several others dragging
payment out until day 60 or so. The company is financially sound,
but consistently juggles between $100,000 and $200,000 in customer
projects. They have little cash on hand at any given time and cannot
purchase equipment or hire additional talent to accelerate their
project "turn" rate.
First, consider the lost revenue based
on the "interest-free financing"
that the company unwittingly provides to its customer base: 12%
annual interest on $500,000 for 30 days would be $5000. ($500,000
in accounts receivable x 12% annual interest = $60,000 /12 months
= $5,000 monthly interest lost.)
Staggering?
Annualize that ($5,000 x 12) and you are looking at $60,000 in interest
that never gets charged, and never gets collected. Then consider
the opportunity cost on top of that. It's been our experience that
contracts or purchase orders caught in the backlog get canceled
at a rate of 15-20% (except in the most specialized industries).
In most cases the customers simply choose not to wait and go with
another vendor. (Remember, a purchase order is not a promise to
either buy or to pay.) The company is losing 20% of $150,000 in
orders every month!
That is $30,000 a month for 12 months,
translating to $360,000 a year. Additionally,
if those contracts or back orders were produced during that same
month, the profit on those orders, after subtracting the cost of
goods and labor, would have gone directly to the bottom line. This
is the opportunity cost, lost simply because the company is forced
into providing no-interest loans for 30 to 45 to 60 days or more
to many of its customers. This situation, unfortunately, is a "way
of business life" in America today. Bill-paying performance
(how quickly businesses pay their trade receivables) has been declining
steadily throughout the decade of the 1990s and promises to continue
on this unfortunate trend.
Many companies publicly admit to stretching
out payments for 30, 60 or even 90 days
on all invoices, with the specific intent of controlling costs and
maximizing profits. There is no doubt that it works for them, but
their cost-saving strategy is executed at your expense if it's your
business waiting for that check.
Consider a client of
mine, a Southeastern furniture manufacturer.
To produce their product, this company requires a long list of necessary
raw materials: raw steel, glass, finishing materials, wood components,
fasteners, etc. Currently they enjoy 30-day terms with most of the
suppliers, but seldom, if ever, does the company have the cash on
hand to take advantage of the 2% discount offered by vendors and
suppliers for fast payment (2% discount within 10 days, net 20).
As a new factoring client, this company
used the money to pay vendors/suppliers in 10
days and
cut the factoring fee approximately in half. Better yet, companies
in this position would do well to consider placing a call to the
credit managers of their suppliers, offering cash payment on delivery
or upon ordering and asking for additional discounts. If the suppliers
need the cash (and most businesses do!), then the discount for COD
terms might be as high as 4 or 5%, which could completely offset
the entire cost of factoring (which is exactly what happened in
this case).
When this client combined the ability
to offset the cost of factoring
with
the increase in production realized by accessing more materials
(to fill more orders within the same month,) the profit generated
from this additional business went straight to the company's bottom
line.
While there are many advantages to
factoring, many businesses are drawn
to the service primarily because factoring can mean an end to the
problems of bad debts. As part of the process, factors will check
the credit of your customers, reducing your overhead for credit
management functions. Invoices of those customers deemed creditworthy
are often purchased on a “recourse" basis. We will go
into more detail on this, but it roughly means this: the factor
purchases the invoice and pays you. If the customer is financially
unable to pay, the factor cannot ask you to return the advance.
If, however, there is a problem with the service or delivery, you
are going to be responsible for making the situation right. (Fair
is fair, yes?)
Chances are, though, that this invoice would not have been funded
anyway because the factor will usually verify or, as we like to
say, "acknowledge" the invoice before funding. This is
simply the factor contacting your customer and verifying that the
goods or services have been received in full as ordered, verifying
the intent to pay and making sure that the payment will be sent
to the factor.
While this part of the process is essential to protect the factor
from buying fraudulent invoices, it is also valuable to the client.
If the factor discovers that your customer is not happy, for whatever
reason (wrong color, wrong quantity, etc.), the factor will immediately
forward this information on to you so that you can correct the problem.
It works as an "early warning system" that avoids complications
created by incorrect shipments sitting on a warehouse floor, delaying
payment and harming the client-customer relationship (not to mention
possibly saving the jobs of shipping personnel around the country).
The
client owns temporary staffing and recruiting agency.
This client works for a large number of customers, most on a regular
basis and others less frequently. Invoices ranged in size from $100
to $3,000. It became apparent to us that if we were to do business
with this particular client, it would have to be on a recourse basis,
meaning that we would have to retain the ability to charge the client
for any invoices that are not paid by their customers. Factoring
on a recourse basis is the next best thing to non-recourse, when
the following circumstances exist:
The sheer number of customers prohibited
us from verifying all of the invoices to be purchased.
Again, the large number of customers made our typical "credit
work" impossible, and experience told us that many of these
customers wouldn't be listed with the credit agencies (D&B,
Experian, etc.) anyway.
While the client's published credit
rating was limited (a 1R2 by D&B,)
a review of their audited financial statements revealed that they
were in a fairly strong financial position. (The reason for their
weak D&B rating was that they hadn't reported to D&B with
any new financial information in several years. As a result, D&B
gave them a low rating. This story isn't unusual at all, and in
fact, it happens all the time, which is why we take the time to
dig beyond the published credit reports if our instincts so guide
us.)
A review of the clients A/R aging schedule
and payment ledger indicated
that a
high percentage of the company's customers paid in full and on a
regular basis.
Given what we had to work with, we structured the following recourse
agreement:
All invoices submitted to us for funding would be listed on what
we call a "Bulk Schedule" (This is simply a cover page
itemizing the receivables to be funded) and submitted electronically
(in spreadsheet format.)
Each invoice would still be entered
into our software, as per usual.
Invoices submitted for funding were to be "spot checked"
on a periodic basis. (This supplemented our usual "verification"
process, giving us the comfort of knowing that, over all, the invoices
were real, in the customers' systems, and in process for payment.)
Invoices not collected within 90 days of funding were to be paid
by the client either with a direct cash payment, a substituted invoice,
or from the reserve account.
Consider the case of
Wood Vision Inc., a distributor of
fine furniture to retailers. The customers run the full spectrum,
from small mom-and-pop operations to large national chains. Because
many of the customers are not verifiable as credit worthy, we decided
to purchase the invoices on a recourse basis. (In fact, it was the
only option available.) If one of the customers should become financially
unable to pay one of the funded invoices, there are several options.
First, the client can just pay back
the advanced amount. Or, second, the
client can request that the money be taken out of the client’s cash
reserve. As a third option, the client can submit another un funded
invoice (from another customer, of course) to replace the invoice
that was funded. Whatever the course of action, it will not be an
arbitrary or one-sided decision. In such cases, we would call and
ask how the client would like to handle the situation, and we would
expect that other factors would do the same.
One of the often overlooked
ways that a funding company can help a growing business is
to use two tools we call purchase order funding and tri-party agreements.
We were recently introduced to a company that had chosen to become
a distributor of circuit boards for computers. Our client was introduced
to us through a broker, as the owner of a relatively new company,
but with an existing customer base (which he had acquired from his
old job) ready to buy his product. His problem was one that we encounter
almost daily: he had orders and customers, but NO INVOICES!
As you might imagine for a firm, like
ours for example, that buys commercial invoices,
this could be a real problem; actually, no, at least not in this
case. In this case we were, upon further review of the information
provided, able to ascertain that our client:
had purchase orders to the tune of $250,000 for product to be delivered
within the next 90 days, had creditworthy customers, had an opportunity
to grab a meaningful share of his market over the next several years,
needed to develop credit with his vendors and suppliers
could generate between $75,000 and $150,000 in monthly volume and,
of course, didn't have the cash to begin to fill his purchase orders.
At least his company was young enough not to have any bank loans
or IRS problems, so we didn't have to deal with that. Clearly,
Our client had enough positive things going on with his business
to warrant our participation. All we needed to do was to convert
his purchase orders (PO's) into invoices and fund those, but before
we tell you how we did it, we need to discuss the topic of PO's
in general.
As I mentioned above, we see PO deals
all the time, and, for the most part, we don't always fund them.
The regular story almost always goes
like this: a prospective client finds his way to us with what, he
proceeds to tell us, is a fantastic opportunity, FOR US, to help
his business.
"You see," he tells us. "I've got this $500,000 PO
from Wal-Mart." (Somehow it's always $500,000 and it's always
Wal-Mart. They must have an entire room filled with nothing but
$500,000 PO's that they send out to naive vendors. They probably
think it's a riot. And besides, what else do they have to do in
Fayetteville?)
"Anyway," our man continues, "all I need is a measly
$350,000 to fill the order (he means to buy the necessary materials
and produce the product) and we're in business. I fill the order,
you fund the invoice, and everybody wins! And, oh, by the way, when
can you wire me the money?"
We really do get calls like this all
the time. Our answer is almost always
the same: Do we do PO funding?
Yes, but not like this. We do it when we have a comfortable factoring
relationship with an existing client, as in "clients we know,
selling to customers we know who pay." We cannot and will not
entertain beginning a relationship with PO funding; it's just too
risky. "What risk?" our friend says. "It's Wal-Mart,
they always pay!" This is true, we tell our new acquaintance
(for he now senses that he is not so much our friend), but the fact
is, it's not Wal-Mart that concerns us. What would happen if we
funded your PO and something goes wrong? It's the wrong color, size,
flavor, it's late, damaged, or otherwise incorrect. What happens
then?
Well what happens is that we, not you,
now own this, this stuff that you cannot seem to sell to anyone.
We funded it, we own it, and now we have to, somehow, GET
OUR MONEY BACK!
And now, back to our client.
The first
thing we did was to see if we could break the PO's down into "bite-sized"
amounts so we could begin slowly. Secondly,
we discovered that most of the product could be shipped, by the
manufacturer, directly to the customer. Upon discovering this, we
recommended that client approach his suppliers (there were two)
with the concept of the "tri-party agreement" wherein
it is written that we, the factor, agree to pay the manufacturer
directly from fundings once the product has been shipped to, received
and accepted by the customer. If the manufacturer has any confidence
in the product, this shouldn't be a problem, and it wasn't. They
shipped the goods and billed our client. Upon receipt, our client
generated an invoice. We verified receipt and acceptance by the
customer and funded the invoice, paying a portion to the manufacturer
and the balance to our client. We chopped the PO's up into smaller
sizes to make everyone comfortable and everyone was - and still
is today, we're pleased to add! The manufacturer was happy with
a new source of regular business, our client was thrilled, as you
can imagine, and we were so pleased with our great new account.
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