A recent article on Investopedia noted that “of the vast number of small businesses that fail each year, nearly half of the entrepreneurs state a lack of funding or working capital is to blame.” You may ask why the focus is not on gross margin or on operating expenses, which certainly are important areas to control. The suggestion is to keep your direct reports accountable for those areas, while owners, CEOs and investors concentrate on achieving return on investment (ROI) targets.
Here’s an example.
Considering the foregoing argument, there are widely used financing alternatives available to companies. Purchase order financing combined with accounts receivable financing (factoring) should not be overlooked, since they contribute to the growth of ROI while minimizing the use of company cash.
The combination of purchase order financing with factoring the receivables has several benefits. This type of funding does not appear as debt on the balance sheet according to GAAP (generally accepted accounting practices followed by the majority of companies), which makes the company more attractive to the owner and any potential investor. A company does not give up any equity or control. The discounts that can be negotiated with suppliers for prompt payment (payment in full FOB for finished goods) typically are greater than the financing fees — or they reduce the financing cost significantly.
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There are a few important reasons to choose this alternative.
It leads to unsurpassed ROI, while conserving cash. In a typical transaction when a company is required to have some skin in the game, let’s say 10% of the cost of goods is put up by the company, and 90% is financed. The ROI, assuming a 50% gross margin on $100,000 of wholesale revenue (assuming a gross margin of $50,000, minus finance feeds for 60 days at $3,750) would be $46,250 in gross profit on an investment of $5,000.
In other words, an investment of $5,000 produces $46,250 of gross profit, which is an ROI of 925%, or 9.25 times the dollars invested. At the same time, the company only gave up 3.75 points of gross margin. The only upfront impact on cash flow was $5,000.
In this transaction, $46,250 of positive cash flow was generated. Funds will be available for ever-increasing future shipments as long as more purchase orders are issued by creditworthy customers. Therefore, a company can sell aggressively without concern that funds will be available to pay suppliers.
Factoring the receivables provides an additional benefit: The company can increase sales by offering extended payment terms to customers while receiving immediate cash against the resulting invoice when issued to the customer.
Obstacles
There is no getting around the fact that the solution above only applies to companies that produce or distribute physical products. However, you may ask how this would apply to companies that manufacture their own products or have to carry goods that are not presold.
This category not only includes manufacturers who need to buy-in on production materials, but also distributors, retailers and those that sell online. In those cases, the financier has to rely on the company’s own financial strength rather than the creditworthiness of the client’s customers. For those stronger clients, supply chain financing is available to pay suppliers and provides a strong boost to ROI as well.
PO financing combined with factoring of receivables can allow firms to grow their bottom line through increased velocity if inventory turns, without continually going back to investors or lenders for equity or bank financing.
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