Financing Alternatives for Businesses
By Kenneth Pogrob, Tabitha Au, and Zalmy Dubin
Whether you are a start-up or have been in business for years, you will at one time or another need financing. The cash flow of a business is arguably the most crucial element to keeping operations running smoothly. Cash flow needs can, and will, fluctuate quite often, due to timing of collections and payments. A business might need cash to purchase inventory, equipment, or to cover a payroll and the cash is simply not available to address the current needs. There is a variety of financing available depending on the cash needed and the financial position of the entity. Financing options can range from traditional methods like lines of credit, to equipment loans, asset based lending, factoring and purchase order financing.
A common method of business financing is a Line of Credit (LOC). A LOC is an arrangement between a customer and a financial institution in which the lender authorizes the customer to draw down funds at any time up to a maximum agreed upon amount. A LOC can be secured or unsecured. When a loan is on a secured basis, assets of a business including accounts receivable or inventory serve as collateral in the event of default. A LOC generally serves to fund growth and expansion of a business, to build up inventory and to fund other short-term cash needs.
The main benefits of a LOC are:
- The customer only pays interest on the outstanding balance. To the extent that there are no borrowings, no interest is due.
- Generally a borrower is not required to pay down principal unless there is a clean-up provision specified in the agreement.
- There is no need to reapply every time cash is drawn on the line.
Equipment loans are more appropriate when a business needs to make a significant capital investment. These are typically structured as term loans since they’re for assets with longer lives and the unspoken rule of business is to fund long term assets with long-term debt. Lenders will generally lend up to about 80% of the cost of an asset, which is then used as collateral for the loan.
The interest rates on term loans are generally similar to those of a LOC. However, there is less risk associated with a term loan than a LOC. This is because a LOC interest rate is usually tied to the current Prime or LIBOR rates which can fluctuate based on market conditions. Term loan interest rates are usually fixed for the life of the loan so the payment is more stable and predictable.
Asset based lending (ABL) is generally suited for businesses with inconsistent EBITDA but ample hard assets such as accounts receivable and inventory, which are used to collateralize the loan. The distinguishing feature of asset based lending is that the borrowing amount is determined by the value of the collateral as opposed to the strength of the company’s financial statement or its credit worthiness. The amount a company can borrow is typically a percentage of the value of the asset pledged.
The borrower benefits from a revolving credit limit that fluctuates based on the company’s actual accounts receivable and/or inventory balance. ABL loans are also subject to less stringent covenants, so borrowers can avoid significant fees as they are less likely to be in breach of set covenants. Borrowers do, however, incur more expenses, as ABL requires close monitoring of collateral. The borrower is required to submit borrowing base certificates on a regular basis and is subject to field examinations and related fees.
Factoring is used by companies that have cash tied up in accounts receivable and cannot wait the usual 30 to 90 day collection cycle. To meet a business’s immediate cash needs, the factoring company purchases the accounts receivable of a business at a discount, typically between 70-85% of the value of the invoice. With a traditional bank loan or LOC, the business is typically limited to their equity or cash flow. With factoring, the borrower benefits from faster funding, a simpler application process, and a higher approval rate relative to traditional bank loans. Factoring also does not require covenants. A drawback with factoring is that many factors will notify the company’s customers that their invoice has been financed.
Another financing option is known as Purchase Order Financing (POF). This involves a lender paying the supplier of the borrower for goods that have been purchased to fulfill a particular customer order. The POF Company will then collect the amount advanced from that customer in satisfaction of that loan. POF lenders are not subject to bank regulations and are, therefore, able to charge higher interest rates and additional fees than traditional financial institutions. This method is usually utilized for short-term needs when a company is strapped for cash and having a hard time getting approved for a LOC or other traditional form of financing.
There are many types of financing available to businesses and choosing the correct one can save businesses money. A good financial advisor can help a business make the decision that is best for its needs.