Factoring…a way to generate valuable working capital and improve the bottom line.

Here's an article I wrote for "Coastal Grower," which will be published in the Fall-2011 issue.

The article was inspired because Bella Carlo recently started River Guide Capital LLC to offer AgQuickPay, factoring and management services, exclusively to agriculture. In the process of selling AgQuickPay, I've noticed that prospective clients who object to factoring often do so because they equate it to debt financing. It is my contention, however, that factoring is much more like equity financing, and hence the article.

"A seldom used means for obtaining working capital in agriculture is factoring. However, factoring can offer great value to agribusinesses.

"Factoring is cash advances from the purchase of accounts receivables by the factor. Factoring is using retained earnings before they are booked. Factoring is the equivalent of offering customers credit cards to pay their invoices. Factoring is similar to equity financing—unconstrained capital. But better yet, factoring does not require owners to contribute personal cash, to use personal or side collateral as guarantees, nor to share control that customarily accompanies outside financing.

"Example of Factoring

"Table 1 illustrates a simple example of factoring invoices. In it, a shipper sells produce to her customer and factors the receivable. The advance rate is 80% and the discount is two percent. The individual transactions for factoring an invoice are identified by approximate chronology.

Table 1. Example of Purchasing an Invoice at a 2% Discount with an 80% Advance

"Factoring works quite well, for instance, for companies that have stumbled in the past or start-ups both of which are poised to expand. Factoring is also good for companies with large opportunity costs on their retained earnings or capital. That is, it’s a great solution for businesses that have alternative uses for their funds other than financing accounts receivables and working capital. Examples of some these alternatives include financing your customers’ business, negotiating better terms with vendors, funding research and development, investing in development and promotion of new products, and/or introducing high-margin specialty and/or seasonal programs.

"Case Study: Funding Growth

"Let’s look at a case where factoring improves the bottom line to a produce shipper with $61 million in sales and a forecast annual growth in sales of 25%. This company’s balance sheet, however, will not support the growth through debt financing as a result of either poor past performance or under capitalization. The causes for the resulting balance sheet are less important here as is the fact that lenders will not lend on a balance sheet that does not pass their underwriting standards.

"In this case, the company has two choices to the fund growth: add equity to shore up the balance sheet or factor accounts receivables. Table 2 compares all-equity financing to factoring using income statements. The table starts with the company’s income statement before growth and the new capital is introduced, entitled “Status Quo.” The “Status Quo” represents the reference point from which to compare the two subsequent income statements resulting from using “All Equity” versus “Factoring” to fuel the 25% growth in sales.

Table 2. An Income-Statement Comparison of Equity Financing to Factoring

"Factoring the firm’s accounts receivables will generate on average $4.7 million dollars per month in cash (advances). The equivalent equity scenario is the owners inject $4.7 million in equity, in cash, to accomplish the same impacts on working capital.[1] In both scenarios, the company uses the newly introduced working capital to improve terms with vendors. With factoring, the new terms will in part offset some (or all depending on the new terms) of the fees for factoring.

"The new capital introduced is first used to pay off the borrowed money under the “Status Quo.” Thus, there will be no interest expense associated with the company’s growth with either “All Equity” or “Factoring.” It is worth noting one difference here between equity financing and factoring. The firm will continue to book the same amounts of accounts receivables with “All Equity;” additional cash will unlikely change customers’ terms. With factoring however, accounts receivables will decrease by approximately the advance rate on the purchased invoices.

"Clearly, the percent change of 220% in net income is much greater under the “All Equity” scenario than the 81% improvement with “Factoring.” But, if you consider the amount invested--$4.7 million—to realize that tremendous improvement, factoring becomes relatively better since no investment is required to sell invoices. The infusion of equity improved net income by $2.3 million over the “Status Quo” for a relative return on the investment of 48% (i.e., $2.3 million divided by $4.7 million). Comparatively speaking, factoring generated a higher relative return of 59%. The business improved its bottom line by nearly $837,000 with factoring over the “Status Quo,” but required no infusion of capital to do so. Instead, the company paid fees totaling $1.4 million for the use of $4.7 million in capital to fuel its growth. So, $837 thousand divided by $1.4 million equals 59%.

"Factoring’s Benefits over Debt

"Factoring has benefits over debt financing too. Debt usually requires the use of personal or side collateral as a way to guarantee it. Factoring doesn’t. Debt is normally issued based on past performance not on projected future actions. Thus, debt financing is attractive for businesses with historical successes and difficult to secure for those that face only a rosy forecast.[2] Factoring, on the other hand, works well when the future is bright.

"In summary, factoring is a great way to generate very valuable working capital and improve the bottom line as the case study illustrated. It provides the flexibility of equity financing but without the need for large personal cash reserves, or the need to share control with outside investors. It’s also a way to raise substantial amounts of capital without personal guarantees and/or the need to pledge assets as security. …and, an adequate supply of cash only helps businesses operate more profitably."

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[1] Additional equity will be needed to support growth when sales vary seasonally. But factoring does not suffer from this seasonal limitation. Invoices generate (additional) capital irrespective of the vagaries caused by Mother Nature.

[2] This explains the origin of the adage, “banks only lend to folks who don’t need it.”

Cash solves all business ills; or does it?

Finally, I'm breaking through my writer's block to start my blog.... I hope you enjoy it; but more importantly, my real desire for writing the blog is to contribute, opine, share, etc., so you will contribute, opine, and share too. Thanks in advance.

My blog will share some of my and Bella Carlo's experiences and insights (however the opinions expressed herein are solely mine) so others and I can learn more from each of them. Lest not forget that as a merchant banker, we do better work and add more value to what we do when we continually learn and share that knowledge with others, especially our clients.

So onward to my first topic.... Does cash solve all business ills?

No, but let me explain, For the sake of simplicity, let's say there are two simple categories of businesses--those doing fine and growing and those hurting. In both cases cash will not solve their trials and tribulation. A good plan with proper financing will help however.

A business doing well and growing will need cash to fuel its growth and sustain its business, a.k.a.paying its bills. And lack of cash could adversely hurt a firm that has good demand for its products and/or services in that it won't be able to finance its growth and that could cause problems. However, that's a good problem to have especially if the company is well managed--i.e., a company with a game plan and a management team willing to execute the plan rigorously. A well-managed company usually can finance its cash requirements either from retained earnings and/or by borrowing against some assets, e.g., its receivables. The decision of which form of financing should be used to fuel growth comes down to identifying the opportunity costs of the available alternatives and then choosing the relatively least costly or most profitable alternative. This type of analysis would/should be in the plan.

A struggling business, on the other hand, more than likely will not benefit from just an injection of cash, even though many managers and owners attribute their problems to the lack of cash. It is usually the case that a firm's problems caused the cash shortages, not the otter way around. Examples of problems that result in cash shortages include, but not limited to, low prices on the sale of products, negative margins on each or all products sold, and/or excessive agings on receivables. If no one in the business is able/willing to change the practices/behaviors creating the problems, then no one should be surprised that no amount of cash will fix the struggling business. To the contrary, an injection of cash without a change in practices may only worsen the situation because nothing will change save the added loss of the newly introduced cash.

We encounter businesses frequently that are looking for cash as a means by which (to attempt) to solve their business problems. From our experience, and ruth be told, owners of these businesses would not know what to do with the cash if they received it. Fixing the business usually means doing somethings differently than they are/were when the problems began. We see this phenomenon way too often and, though we focus on food and agricultural, I know this happens just as often outside of agriculture. Furthermore, it happens in all types and sizes of companies--from privately held to publicly owned and from small, unknown family businesses to large, well known icons such as GM.

Bella Carlo's answer to the question is no, but a business plan and a management team committed to the execution of the plan do go a long way to solve most business ills. (I realize my statements here sound self serving, but I believe this to be true because I have lived it.). We, at Bella Carlo, spend a lot of time trying to sell the value of a detailed business plan (and not always successfully). And to this end, we cannot emphasize enough the importance of the details. It is not uncommon to see (at times written, though seldom) plans that start with pro-forma financial statements that, of course, predict profits, but cannot explain the means by which those those profits are attained. This is always suspisious. For example, if you are selling cartons of produce, but cannot articulate how many boxes need to be sold to equal the estimated total revenues, then the plan lacks the requisite details. Without details, the rest of the story that outlines the path to the promised land is just a hope. And hope is not a strategy.

Plans that lack details, especially for troubled firms, raise doubt in the most important person(s) the business is trying to recruit--the investors with cash. The reason for this is that P&L information will not tie to the balance sheet, which will then make it difficult to estimate cash flows. Without estimates for cash flows the business will be vulnerable to unforeseen issues (a common situation in all businesses) that could lead to problems. Investors know business is all about problems, but they want to understand the plans for handling the unforeseen. Each investment is about two things: generating a return and managing the risk around the investment.

This is a good place to stop. My next topic: cash is king!