An alien from an all-cash planet would gaze in wonder at the trade credit system that runs the Earthly economy. Let’s review:
Jack Brown invests his life savings to open a surfboard manufacturing business, MI Board, Inc. It does well, attracting the interest of the media, surfers and retailers. A few small shops in California put his boards on consignment. They turn some heads, win some competitions, and MI lands $300,000 in initial orders from Becker, RonJon’s and HSN. Cool.
After celebrating, Jack reads the purchase orders from his new customers.
All three want product delivered in 30 days. All three want Net 45 Day terms. Jack ecstatically calls his suppliers. Because MI Board has no credit history, the suppliers want cash.
So essentially Jack ends up loaning $300,000, unsecured, without interest, to his customers for 45 days. Meanwhile, he has to scrape together the upfront money for his suppliers and, of course, meet payroll for his suddenly inflated staff. Until the retailers pay him, which might be 60 days or more, he will have serious negative cash flow.
This phenomenon called “trade credit” is especially hard on small, growing companies. Their customers demand credit. Their suppliers demand cash. The result is a serious cash flow gap that threatens the life of the young business.
A factoring line is an ideal tool to help bridge this gap. Jack can accelerate his cash flow, meeting the demands of his suppliers and his staff. By factoring, Jack will sell the receivables (the loans he’s made to his customers) to the factoring company at a discount, receiving much-needed cash flow at the time he delivers his surfboards. The factoring company then waits the 45 days or however long it takes Jack’s customers to pay.
In some cases, Jack’s supplier will accept an “assurance letter” from the factor. This says the factor will pass funds directly to the supplier as soon as the invoices are factored. The supplier’s perceived risk is reduced, as there’s no question of where the funds will go after Jack receives them. In many cases a factor’s assurance letter will convince a supplier to offer credit terms where he would otherwise require cash.
Each situation requires a careful analysis of the elements of trade credit to determine how to fill the cash flow gap. A factoring line and the tools a factor can provide will give business owners the flexibility to respond effectively to growth opportunities as they arise.