FACTORING When Money Flows – Smoothing the business cycle makes sense

In the five and half years since he joined business financier S H Lock, Jason Williams has seen average invoice payment times drag out from 50 days to just under two months. It makes mockery of 30-day payment terms.
As the company’s business development manager, Williams is only too aware of the discomfort many businesses feel when they demand clients pay outstanding invoices in one breath and tout for more business in the next.
The dilemma is especially real for owner-operator businesses where the person making the sales and the invoice-chaser are one and the same.
While most large companies still issue invoices due on the 20th of the following month, many clients know they can get away without honouring payments within that cycle.
This has spurred many companies to assume late payment is now the rule rather than the exception, says Williams. Many business people hold back from chasing up overdue invoices for fear they may compromise the possibility of repeat business.
Williams suspects this also explains why most firms are reluctant to invoke late payment clause when invoices reach past due date.
At best, slow payment syndrome blocks business growth. At its worst it sounds the death knell for floundering enterprises.
Williams has seen first hand the effect on companies trying to sell goods and services to other businesses on normal trading terms. Many struggle to find sufficient cash to meet business running costs.
The strain is especially evident among wholesalers and manufacturers who have to pay once goods are shipped.
“Lack of cash flow, rather than lack of sales, often prevents companies from developing beyond the initial stages,” says Williams.
He cites expansion efforts by typical owner-operated giftware company as prime example. The banks were reluctant to lend to the company without property security. When the owners eventually secured bank loan to buy extra stock their growth was small and part-time affair.
The owners had failed to factor into their planning the disproportionate amount of time it would take for them to get paid.
Recruitment companies face equally challenging hurdles. Those that fail to pay their temps on time find they simply go elsewhere.
“So imagine the benefit of having clients paying 80 percent or more of what’s owed ‘on delivery’,” says Williams.
“Access to cash smooths the whole business cycle and allows companies to both grow and ride out the tough times.”
Most local companies know that factoring options exist.
But, unlike overseas where factoring is handled by the banks, in New Zealand factoring needs are met by separate and specialist companies. notable exception is the BNZ which offers debtors’ financing service of its own.
Scottish Pacific Business Finance director David Cooper argues this specialisation creates the false impression that factoring must be lending of last resort.
Cooper estimates between 300-500 Kiwi firms use factoring as short-term bridging finance on an ongoing basis. There’s no doubt in his mind that non-bank financiers must continue to demonstrate to local businesses how factoring can foster company growth.
The average loan has now burgeoned to around $100,000 – fact that prompts Cooper to believe larger firms are now starting to use factoring as growth tool.
He also believes resistance to factoring is lessening, especially amongst the professional community.
How does factoring work? Kiwi firms typically plump for the full-service option.
Factoring companies are willing to fall in behind the banks (concerning control of company) as long as they have security agreement giving them first charge over the company’s debt and sometimes any other assets.
Once this agreement is in place the company cuts an invoice and sends copy to both its customer and the factoring company. On receipt of that invoice the factoring company immediately provides access to up to 80 percent, and sometimes more, of the value of the invoice.
Having collected the outstanding invoice on the due date the factoring company will pay the client company the remaining 20 percent less charges (up to two percent of the total invoice) and interest at bank rates of around 11 percent annually (or flat rate of around five percent).
Based on Williams’ calculations, the average cost incurred by companies using S H Lock’s full service factoring option is three percent of turnover.
Although less popular, some companies opt for second stream of factoring called invoice discounting or undisclosed factoring.
The factoring company still takes charge over the debt and continues to pay out around 80 percent of the value of the invoice. But the discounting option is not disclosed to the client nor is there any debt collecting involved.
Companies select factoring options based on their own financial strengths and weaknesses. Williams notes more mature companies with more robust balance sheets tend to favour invoice discounting, unless they specifically want third party involved in collecting their invoices.
“The companies that worry most about limited cash flow typically lack any understanding of how to get out of the predicament they’re in.”
In Cooper’s view, many companies fail to grasp that factoring is more cost-effective option than simply offering four percent or more discount for prompt payment. That’s because discounts are seldom sufficient inducement to encourage prompt payment.
“Even if client accepts five percent discount on $100,000 invoice, the company still has to wait on average around 45 days to get paid,” says Cooper. “Whereas with factoring the funds are virtually immediate while the cost is substantially less than $5000.”
It is possible to offset cash-flow uncertainty by having fewer yet larger clients that are historically good payers. But according to Williams selling into major chain can be Catch 22.
“Large chain stores are more likely to pay on time but there’s always the risk associated with having too many eggs in one basket. Especially if your company, almost by default, becomes an extension of the major chain’s business and they unexpectedly have new buyer who favours new supplier.”
Who should consider factoring? At face value most companies could benefit. But, as Cooper says, it’s niche product and therefore ideally suited for companies going through particular business cycles.
In practice, most firms tend to utilise factoring option facility for two to three years before reverting to more traditional funding or other non-bank alternatives such as stock and debtors’ overdrafts.
“If company’s ledger grows from $50,000 to $200,000 the business can put $180,000 back out the door virtually immediately,” says Cooper. “The banks would want further security.
“An inability to pay debts on time can affect company’s credit rating and may see it relegated to ‘cash only’ basis. There are also penalties for directors seen to be trading within varying degrees of insolvency,” he says.
Cooper claims around 30 percent of his company’s clients would have gone out of business fairly quickly or suffered long and slow death had they not used factoring to free up cash flow.
“The impact factoring has depends on how the cash that’s freed up is used. Ideally it should be used to fund the fundamentals of the business,” he says.
“Don’t fall into the trap of leaving factoring too late. It’s not cure-all for bad business.”

Still not sure whether factoring is the right option? Scottish Pacific Business Finance director David Cooper advises companies to ask themselves three key questions.
1 If we had additional cash in the bank today, how much more product could we import?
2 What profit can we make?
3 Can we afford to pay factoring company and still be ahead of the game?

Mark Story is regular contributor to Management.

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