Obtaining working capital through receivables and other assets

For many business managers, factoring and commercial finance are chilling options. They indicate dying companies that must sell or pledge assets and pay exorbitant loan rates in desperate efforts to stay in business.

Many troubled companies had to take such action in the past and some still do. Yet, for many other growing small and medium sized companies, factoring and commercial finance are useful tools under the right circumstances.

My daughter Mel Smith (nee Ermila Jayasuriya), who is the founder/Managing Director of the Winter-in-Venice personal care products range in the UK, is a firm believer in factoring. At 26 years, she started her company in the UK with £ 65 and a telephone directory. Within eight months she made £ 1 million and she only had factoring as a support to strengthen her cash flow for growth and the sustainability of the rapidly expanding business.

In 1998/’99 she won three British Awards, i.e., Outstanding Entrepreneur of the Year, Most Innovative Female Entrepreneur of the Year, and Best Packaging Award. She had no problems of having to deal with a weak cash flow. Factoring saw to it that the operation throughput was without interruption.

Factoring involves the outright purchase of accounts receivable and may include an advance to provide immediate cash. It requires that customers be notified of the change in receivables ownership.

Commercial finance involves using accounts receivables or other assets as collateral for loans and does not require notification. The term asset financing is being increasingly used as a more accurate description of this type of transaction and is gradually replacing commercial financing.

As a result of the nature of factoring and commercial finance transactions and the risks associated with under-capitalised borrowers, financing costs are higher than for conventional loans. Certainly, selling or pledging corporate assets is less desirable than borrowing on a promissory note at a lower interest rate. With rare exceptions, a company with access to unsecured funds would have no need of these secondary forms of financing.

Such financing can, however, make an important difference to a fast growing cash-hungry company. Factoring and commercial finance sources have provided the funds to overcome the early growing pains of companies such as The Diner’s Club, Playboy Enterprises, Tropicana Products, and United Artists, among many others.

Getting a background

To know when and under what circumstances these financing methods may be employed to best advantage requires an understanding of how they operate. Factoring dates back several centuries, as early as the fourteenth century. Sales agents involved in foreign trade began to purchase accounts receivable.

This practice expanded during the period when European nations were exploiting and colonising the world. The East India Company and the Hudson Bay Trading Company were among the large companies that not only evaluated the credit worthiness of overseas customers but also handled documentation and factored accounts.

Commercial financing started early in the last century with the onset of mass production. Since it was initially a new form of receivables financing, manufacturers usually associated commercial financing with factoring. It was a turbulent period when loan sharking and forced liquidation were not uncommon and ‘the factor’ was a bogeyman. To fall into ‘the hands of the factor’ was to have all your customers think that you were on the verge of collapse.

Recent changes

The nature of this sector of the financial market has changed substantially over the past 10 years in the following ways:

Banks are now the dominant force in what was once the province of specialised independent lenders. Banks have acquired several factoring and commercial finance companies and, in many cases, have established their own secured lending departments. The small independent finance company is a vanishing breed.

The use of joint financing, in which banks and commercial finance operations supply portions of funds at their normal interest rates, is increasing. This arrangement provides larger collateralised loans at lower interest rates than finance companies do.

Access to the commercial paper market has enabled factoring and commercial finance sources to reduce their own interest expense and hence, to lower their rates.

Commercial finance applications have also expanded as a result of a general capital shortage which has strained conventional bank credit lines. In addition to receivables financing, commercial finance, for instance, now includes inventory loans, equipment and machinery loans and leasing, import financing, export financing and financing of leveraged acquisitions.

Since cost of funds for banks are cheaper than leasing and factoring companies, more and more customers are moving from leasing and finance companies to banks. The modern bank is more a one-stop Departmental Store, i.e., a customer can get a lease, insurance, and a loan in one location.

The exception

Whereas conventional credit availability is related directly to borrowers’ financial statements, factoring and commercial finance sources are more concerned about the quality of the collateral and the borrowers’ ability to generate sufficient cash flow. Thus, factoring and commercial financing sources show reluctance to support the following types of businesses –

• Industries in which the gross profit percentage is very narrow and the turnover slow.
• Companies providing professional services.
• High technology companies such as makers of medical analysis equipment and specialised instruments for flight and shipping.
• Those businesses that sell on consignment or with a ‘right of return’ such as jewellery manufacturers, car sales houses, etc.
• Certain types of service industries such as advertising and travel agencies.
• Companies like building contractors which complete large contracts on the basis of partial payment.
• Companies that solely provide goods or services to government corporations and departments since it is very difficult to collect the dues. The delay, sometimes running into several months, causes significant erosion in margins.

Factoring vs. commercial leasing

Factoring: A factor promises to pay its client on the maturity dates of purchased invoices and assumes responsibility for collection – in effect guaranteeing the credit of customers. Factoring can also provide funds immediately in the form of a cash advance against the purchase of accounts receivable. Following the initial purchase of receivables, new receivables become eligible for purchase to provide a continuous flow of funds. While some companies use factoring as a cash flow mechanism, other companies retain a factor primarily for credit and collection services to reduce overhead and free executives for more productive tasks.

Commercial financing: This type of loan which began to outpace factoring about 10 to 15 years back provides funs according to the collateral value of the borrowers’ assets. The basic format is a loan collateralised by accounts receivable. The lender supplies funds in direct relation to the amount of receivables pledged, less a reserve against returns and allowances. The borrower draws against the amount available as funds are needed. Banks have now become increasingly receptive to such loans.

Where to turn?

Factoring and commercial financing make the most sense for companies needing an infusion of working capital to produce a steady increase in sales and profit. However, factoring and commercial financing can also give companies that are losing money time to achieve a turnaround.

An asset financier can ride a downhill course longer than an unsecured lender and is less reluctant to intervene in such situations; of course the financier must have confidence in the management and the recovery plan. This assumption of additional risk is, in my opinion, of significant value to the economy because without it many companies, now revitalised, would never have had a second chance.

(Nalin Jayasuriya is the Managing Director & CEO, McQuire Rens & Jones (Pvt) Ltd. He has held regional responsibilities of two multinational companies, of which one, Smithkline Beecham International, was a Fortune 500 company before merging to become GSK. He carries out consultancy assignments and management training in Dubai, India, Maldives, Singapore, Malaysia, Indonesia and Bangladesh. Nalin has been Consultant to assignments in the CEB, Airport and Aviation Services and setting up the PUCSL. He is a much sought-after Business Consultant and Corporate Management Trainer in Sri Lanka. He has won special commendation from the UN Headquarters in New York for his record speed in re-profiling and re-structuring the UNDP. He has lead consultancy assignments for the World Bank and the ADB. Nalin is an executive coach to top teams of several multinational and blue chip companies. He is non-Executive Director on the Boards of Entrust Securities Plc and Eswaran Brothers Exports Ltd.)