Most consulting companies are launched with very little capital and few assets. They usually do not have a substantial cash reserve. The company operates month-to-month, using incoming revenues to cover expenses. This approach can work for small companies. However, it can create financial problems if your company is growing. This article discusses how to handle this situation. We cover:
- Revenue and payroll
- Early payment discounts
- Finance slow-paying invoices
- Advantages
- Limitations
- Qualification
1. Revenue and payroll
Most cash flow problems for small and midsize consulting companies happen because the companies have small cash reserves. Expenses for delivered services are often due before customers pay their invoices. This situation often leads to cash shortfalls that affect your ability to cover critical company expenses. Let’s look at the problem in more detail. We’ll then discuss some ways to manage this situation.
a) Revenues
The most common billing strategies for consulting companies are hourly and milestone billing. Hourly billing is simpler and easier to manage. The consulting company invoices the customer regularly for the accrued hours.
Milestone billing is more complex. The project is divided into several milestones, and the consulting company sends an invoice only when a milestone is reached. Invoicing is usually irregular and depends on how quickly you reach each milestone.
Most consulting companies must wait 30 to 60 days to get paid after submitting their invoices. Customers often demand net-30 terms, especially if they are a large company. Large customers consider payment terms to be non-negotiable. Your consulting company must provide terms if you want their business.
Companies with hourly billing can have more stable revenues than those with milestone billing. However, in both cases, revenues are often delayed by 30 to 60 days based on the payment terms they offer their customers. This situation can cause problems with your ability to pay expenses.
b) Expenses
Payroll is your highest and most important recurring expense. Your team is the most valuable and essential resource of a consulting company. It is also an expensive resource because experts in fields common to consulting (e.g., IT, finance, marketing, etc.) usually command high salaries.
Salaries usually come due on a weekly, biweekly, or monthly basis. However, revenues associated with the work the consultants did may be delayed for several weeks. This delay depends on your billing strategy and negotiated payment terms. Payroll is often due before your customer pays the invoice for the services. Consequently, your company must cover payroll from its cash reserves.
This situation creates a problem for companies with low cash reserves. The problem becomes more challenging if your consulting business is growing quickly. You run the risk of getting into financial problems. There are two ways to manage this situation and improve cash flow.
2. Early payment discounts
A common way to improve cash flow is to offer an early payment discount to select clients. The client gets a 2% discount if they pay your invoice within ten days. The client still has the option to decline the discount and pay the total amount on their usual terms. Clients like early payment discounts because it’s flexible and improves their profits when they use them. It can be a great tool to improve your cash flow and client relations.
Early payment discounts have one important limitation. Your client has the option to use them or not. Consequently, you never know if the invoice will get paid early. Use these discounts only if your company has minor cash flow problems.
3. Can you finance your invoices?
Consulting companies that need more reliable cash flow should consider factoring their accounts receivable. This solution allows companies to finance their slow-paying invoices. It improves your working capital and provides funds to cover payroll and other expenses.
Factoring transactions are usually structured as the sale of your invoices rather than a loan. This structure has several advantages for small and midsize companies.
a) How does it work?
The factoring company buys your invoices in two instalments. The first instalment is called the advance and covers up to 90% of the invoice value. The advance is deposited into your bank account once your company fulfils the services to the customer.
The remaining 10%, less the factoring fee, is paid as a second instalment once your client pays the invoice in full. This payment settles the transaction. To learn more, read “What is Accounts Receivable Factoring?”
b) Pre-billing
Some consulting companies pre-bill their clients for work. These invoices often come due before the work starts. Pre-billed invoices cannot be financed using factoring. Factoring can be applied only to invoices for work that has been completed and approved by the customer.
4. Advantages
An accounts receivable factoring line has several advantages designed to help growing consulting companies. The following five benefits are popular among consulting companies:
a) Improve cash flow quickly
The most important advantage and the reason companies get factoring is that it can improve cash flow quickly. It provides financial stability and a platform for growth.
b) Offer net terms to customer
A factoring line allows you to offer payment terms to customers. You always have the option to finance the invoices if your company needs funds.
c) Add new clients with confidence
Factoring lines are adaptive and can grow as you increase your billable projects to quality customers. This benefit makes factoring an ideal solution for fast-growing consulting companies.
d) Simple qualification
Factoring lines have easier qualification requirements than lines of credit. This benefit makes factoring an ideal solution for companies that can’t meet conventional underwriting requirements.
e) Fast deployment
Factoring lines can be deployed quickly. In some cases, lines can be underwritten and funded in a week.
5. Limitations
While factoring has several advantages, it has two limitations that consulting company owners must also consider.
a) Solves one problem only
Factoring lines are designed to solve a single problem. They improve your cash flow if your problems are due to slow-paying clients. Cash flow problems that arise from other reasons, such as low sales or profitability, cannot be fixed with factoring and require other solutions.
b) Relatively expensive
Factoring is more expensive than a comparable loan or line of credit. Consequently, it should be used only by consulting companies that have profit margins above 20%.
6. Qualification
The qualification process for an accounts receivable factoring line is easier and faster than for a loan of comparable size. This quick turnaround can occur because factoring companies use a simplified due diligence process to determine the quality of the invoices and find potential issues.
a) Creditworthy customers
The most important requirement to qualify for factoring is to have high-quality invoices from creditworthy clients. Factoring companies check the commercial credit of your customer using credit bureaus such as Dun and Bradstreet.
b) No encumbered A/R
Your accounts receivable must not be pledged as collateral to a lender and encumbered by a lien (or hypothèque).
c) No major legal or tax problems
Factoring can be used in turnaround situations by companies that are experiencing some challenges. However, the company must not have serious tax or legal problems that could force it into insolvency.
d) No risk of immediate bankruptcy
The company must not be at risk of immediate bankruptcy.
Get more information
We are a leading factoring company and can provide competitive terms to Canadian consulting firms. For information, get an online factoring quote or call us toll-free at (877) 300 3258.