Saturday, August 6, 2011

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."

[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.”