Summary: Companies that finance their accounts receivables typically do so because they can’t afford to wait up to 60 days to get paid by their clients. Financing their receivables solves this problem and allows them to improve cash flow quickly.
On the other hand, companies that look for inventory financing are trying to solve a different set of challenges. They either need funds to grow their inventory, or they need to leverage inventory that was previously purchased.
This article explains alternatives to finance accounts receivable and inventory. It also discusses the pros and cons of each option and helps you understand how to best use each solution. Lastly, we also discuss the typical challenges that small businesses face and provide suggestions to handle them. We cover the following:
- Accounts receivable financing vs. inventory financing
- Accounts receivable factoring basics
- Accessing funds tied to existing inventory
- Financing large inventory purchase orders
- Typical financing scenarios
1. Accounts receivable financing vs. inventory financing
Accounts receivable financing and inventory financing serve two very different purposes and should be deployed to handle different challenges. Accounts receivable factoring improves cash flow. Inventory financing, on the other hand, can be used to improve cash flow or to acquire inventory. Thus, the decision between accounts receivable factoring vs. inventory financing depends on your company’s circumstances.
Factoring can be an effective financing technique if you have accounts receivable due from creditworthy clients. It’s more cost-effective and easier to obtain than inventory financing solutions. In our experience, most companies should consider this option before trying an inventory financing solution.
Inventory financing solutions are usually more expensive and harder to get than receivable financing solutions of comparable size. They work best if you have already exhausted better alternatives and you need to:
- Leverage funds from existing inventory
- Get raw materials (inventory) to manufacture goods
- Pay suppliers for pre-sold finished goods
Each of these situations uses a different inventory financing solution. The following sections cover these situations in detail.
2. Accounts receivable financing basics
Accounts receivable factoring allows you to finance receivables from creditworthy commercial customers. Most small and midsized companies offer payment terms to their customers. These terms give their customers 30 to 60 days to pay an invoice. However, many small companies don’t have sufficient cash reserves to cover company expenses while they wait for invoice payments. Consequently, they risk getting into cash flow problems.
Factoring accelerates the funds tied to those receivables. It provides working capital to cover business expenses and to make new investments.
a) How does A/R factoring work?
Factoring transactions are typically structured as the purchase of your invoices by a finance company. The line is usually designed to work similarly to a line of credit secured by accounts receivable.
The factoring company buys your receivables and pays for them in two installments. The first installment covers up to 85% of the face value of your eligible accounts receivable. It’s deposited into your bank account shortly after you finance the invoice.
The remaining 15% is rebated to you, net of factoring fees, once your customer pays for the invoice in full. This concludes the transaction, though most companies use factoring regularly.
Learn more: Read “How does accounts receivable factoring work?”
b) Advantages and limitations
The main advantage of factoring is that it can provide working capital quickly. They are also flexible because the financing line is tied to your invoices. Consequently, the line can increase as your sales grow. Additionally, the factoring lines have simple qualification criteria. Small businesses can qualify as long as they have high-quality invoices that aren’t subject to liens.
Factoring has some limitations, though. It is more expensive than a line of credit of comparable size. Consequently, your business needs to have profit margins that are high enough to support the cost of financing. Additionally, the line can only finance invoices. It won’t help if your needs exceed your accounts receivable balance.
3. Accessing funds tied to existing inventory
Many small companies have to pay for their inventory shortly after receiving it. Consequently, building up their inventory ties a substantial portion of their funds. This has the potential to create cash flow problems if their cash reserves are low.
An inventory financing line allows you to leverage existing inventory that has already been paid for. This can improve your cash position and provide funds to cover company expenses.
Learn more: “How does inventory financing work?”
a) Limitations of inventory financing
Inventory financing has some limitations that business owners must consider. In our experience, these limitations restrict the usefulness of this solution to a narrow set of circumstances.
Setting up a line is expensive because of the due diligence requirements. Lenders often have to perform on-site appraisals and periodic collateral and financial reviews. Furthermore, lines are relatively expensive when compared to other solutions.
Qualifying for a line is difficult. Companies must be profitable, sell easily marketable inventory, and commit to high usage volumes. Lastly, inventory financing lines don’t provide as much funding as business owners expect. Most inventory financing lines provide around 70% of the Net Orderly Liquidation Value (NOLV) of the inventory, or 50% of the purchase price, whichever is lower. Note that the NOLV can be substantially lower than what the company bought the inventory for.
4. Financing large inventory purchases
Companies that need to buy large amounts of inventory have two options. The option they use depends on their needs and circumstances. Companies that resell finished goods should consider purchase order financing. On the other hand, manufacturing companies that need raw materials or larger re-sellers should consider supplier financing.
a) Purchase order financing
Purchase order financing helps small companies that resell finished goods, aren’t direct manufacturers, and, have a large purchase order from a client. This solution covers the supplier expenses associated with the order. It enables you to buy the goods, fulfill the order, and book the revenue.
PO funding works well if your profit margins exceed 20% and you buy your products from well-known suppliers. It is available to small companies, and the line can grow to match your orders as long as they meet the funding criteria.
To learn more, read “How does purchase order financing work?”
b) Supplier financing
Supplier financing is commonly used by manufacturing companies that need to buy raw materials to manufacture their goods. It usually works by having the finance company intermediate the purchase of raw materials. The finance company buys the materials from your supplier, pays for them, and then resells them to your company for a small markup.
This solution is available to small and midsize manufacturing companies and resellers. To qualify, your company must be profitable, have a track record longer than 3 years, and be credit insurable.
Learn more by reading “How does supplier financing work?”
5. Typical financing scenarios
This section covers four typical financing scenarios that small companies encounter. It provides the common way to finance the transactions. Note that every company’s situation is different, and you should consult with your finance team or an advisor before using a specific financing solution.
a) Need working capital and have substantial A/R
Companies with substantial accounts receivable and need funds to pay for inventory (or other expenses) should consider accounts receivable factoring. If it covers all your needs, this solution will usually offer the most flexible and cost-effective financing.
b) Need working capital and have excess inventory
Companies with excess inventory that need working should consider accounts receivable factoring due to its advantages. They should only consider adding inventory funding if the factoring line is not sufficient to cover their need and if their profit margins support adding the inventory financing line.
c) Need raw materials to manufacture a product
Companies that need raw materials to manufacture a product should consider supplier financing. While a receivable factoring line can help, in our experience, factoring usually does not provide sufficient funds to pay for the raw materials and cover operating expenses.
d) Need funds to pay for pre-sold finished goods
Companies that resell finished goods and have a large purchase order should consider purchase order financing. It can be an effective solution to finance pre-sold inventory that exceeds your available resources.
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