Many companies struggle to have enough money on hand to meet their financial obligations. This is the definition of a “cash flow” problem. To address this problem, companies generally take one of two approaches:
- Using other people’s money (OPM), that is, borrowing; gold
- Bootstrap the business using its own assets and financial resources.
Most business owners instinctively look to loans as the solution. This article looks at Bootstrapping as a viable alternative.
Other people’s money
The use of OPM involves equity financing (selling a part of the business and therefore part of its autonomy) or debt financing (borrowing). This article focuses on debt financing.
“Debt” is money owed to another person or institution. If it is used to address a cash flow problem, it can be a snag on the neck of a business. When a business “borrows” money (that is, takes a loan), it incurs a debt that must be repaid. The repayment includes both the principle (the amount borrowed) and the interest (the fee to be paid to the part that slows down the money).
Debt places a constant demand on cash flow. That is because you are required to repay the loan through monthly installments. Whether your business is having a good month or a not-so-good month, you must direct funds to the lender or face the possibility of default. If you do not comply, the lender has the right to foreclose and take the assets necessary to pay the debt in full.
Impact of OPM on the balance sheet
The act of borrowing forces a double entry on a company’s balance sheet. The cash acquired under the loan becomes a “Cash” Asset on the books. However, a compensatory liability must also appear because that money is not yours and must be repaid.
This is an important distinction because one of the ratios used to assess the financial health of a business is the debt-to-equity ratio. This ratio is calculated by first taking the value of a company’s assets and subtracting its liabilities. The rest is the assets of the company. Then the value of the liability is divided by the value of the equity to determine the ratio. The higher the index, the greater the risk that the company will not be able to meet its loan repayment obligations.
This relationship can affect the ability to borrow more money. It can also affect the willingness of suppliers to extend payment terms to your business. A highly leveraged company can pose low credit risk, which can lead to vendors demanding cash payment for merchandise.
Starting the company
Bootstrapping does not have the negative potential of borrowing. When starting, use existing company resources to take advantage of growth. This leverage involves understanding all the assets your business has and how to capitalize on them.
For companies with business-to-business (B2B) and / or business-to-government (B2Gvt) transactions, one of the best assets to leverage is their accounts receivable. Accounts Receivable (A / R) is the volume of money owed to you for the product delivered and / or the service provided. It is a debt owed to you by another company or government agency.
Unfortunately, you cannot spend A / R. That money is not in your bank and cannot be used to pay payroll, buy supplies, or pay taxes. However, you can convert that A / R to cash without pressuring your customers to change their payment terms. The solution is to factor the invoices. “Invoice Billing” is the process of selling individual outstanding invoices for cash. It is a transaction that remains exclusively on the Active side of the ledger, as it converts accounts receivable to cash. In an invoice factoring transaction, you are not borrowing money; you are selling an asset. Therefore, there is no liability entry on your books.
Under what circumstances can factoring be used?
The use of Billing is a right granted to a company under article 9 of the Uniform Commercial Code. A company can “assign” the right of payment to a third party: a factoring company. There are very, very few situations in which your entitlement to the assignment does not apply. This means that any B2B or B2Gvt company can use invoice factoring as a means of solving a cash flow challenge.
What financial institutions offer invoice factoring?
While some larger banks have departments that do true invoice factoring, most do not. One reason is that, in general, the underwriting criteria for Invoice Factoring differ from a traditional business loan. But because banks are regulated by the Federal Reserve, those with bill factoring departments will typically apply the same underwriting criteria for both loans and factoring. This means that they will be looking very closely at the personal credit and business credit of those applying for a factoring facility. If those scores are not good, the application will be rejected.
Independent finance companies have more room for maneuver. Its main consideration is the solvency of its client, the entity obliged to comply with its invoice. If your business credit rating is good, the probability of winning a factoring facility is very high. Your business credit and / or your personal credit score will have little impact on the financing decision.
When faced with a cash flow problem, most business owners impulsively seek to borrow money. This is a viable route, but it is important to understand the potential challenges:
- Add a liability to your balance
- It affects your credit rating
- Increase your debt to equity ratio
- Imposes an additional monthly demand on cash flow
- Automatically creates the possibility of default and foreclosure.
Bootstrapping and the use of Billing is a reasonable alternative. It offers a fast and efficient way for a company to use its existing resources to solve a problem. It is inexpensive and, by law, universally applicable. Used correctly, it can help a business survive tough times and prosper when times are good.