Other Financing Methods to Consider

Trade Credits

Trade Credit - also called Accounts Payable - is the single largest category of short-term credit and is especially crucial for small businesses. Trade credit is a customary part of doing business in most industries. It can be a contractual arrangement or an informal agreement that permits a business to pay its supplier over a given time period rather than upon delivery of the goods. A firm that does not qualify for credit from a financial institution may receive trade credit because an existing relationship has familiarized the seller with the creditworthiness of the customer. Since a large part of the supplier's ability to accept delayed payments could be your credit worthiness (which is evidenced by your history of prompt payment), it is vital to pay debts in a timely manner. If you know you will be late on a payment, communicating this to your suppliers, along with a reasonable explanation and new date of payments, will help your favorable relationship continue.

The effect of trade credit can best be seen by example. Assume a firm makes average purchases of $2,000 a day on payment terms of net 30 days. On average, it will owe 30 times $2,000 - or $60,000 - to its suppliers. If its sales (and consequently its purchases) double, accounts payable will also double to $120,000. The firm will have automatically generated an additional $60,000 of financing through trade credit. Similarly, if the firm can negotiate extended terms of credit from 30 days to 40 days, accounts payable will expand from $60,000 to $80,000, which lengthens the average payment period and generates additional financing.

Factors

Finance companies assist businesses that are expanding and experiencing a cash shortage by purchasing the business's accounts receivables. In factoring, the receivable is purchased at a discounted rate and the finance company pays the business immediately. There are two types of accounts receivable sales: recourse and non-recourse factoring. In a recourse transaction, the business retains part of the risk of customer default and is ultimately responsible for any short fall. In a non-recourse situation, the finance company takes on all the rights and obligations of the receivable, including the risk of default by the customer.

Finance companies charge a fee that is usually 2 to 6 percent of the receivable. The calculation of this fee depends on the following variables: volume, size, and number of invoices; customers' credit; location of the customers; and length of time of payment. some companies charge an additional fee if the customer is late on payment, while others have one flat fee. Upon payment by the customer, the remaining value (10 to 30 percent), minus the fee, is sent to the business.

There are two methods of factoring, called traditional and spot. With traditional factoring, the finance company obtains the rights to an entire stream of receivables. This is best for companies with at least $1 million in annual sales. Spot factoring is the buying and selling of a single order or account. Businesses that only use factoring for a limited time or purpose, such as seasonal employees, often prefer the spot factoring method.

It is important to keep in mind that, unlike banking, there are not regulatory agencies overseeing the business practices of factoring companies. Most factors will provide prospective clients with a list of former and current clients as well as references from local lending institutions.