Without the working capital necessary to carry out the plan successfully, all planning is futile. If a business sells to customers on terms, the availability of working capital is contingent upon cash flow timing. Typically, a business will experience a cash flow gap between when cash is required for inventory, payroll, and operating expenses and when cash is received from customers paying on terms. Consider the following simple illustration of the timing difference that accounts for the cash flow gap:
Day 1: Your business purchases materials on N/30 terms from suppliers;
Day 3: Your business receives the materials and begins production (which takes five days);
Day 8: Your business begins shipping goods to customers on a N/30 basis;
Day 14: Payroll for the middle of the month is due;
Day 30: Payroll for the end of the month and supplier invoices are due;
Day 48: Your customer pays you.
The cash gap in this scenario is 34 days, from day 14 when payroll is due to day 48 when the customer makes payment. The cash gap consists of two pay periods and a payment to your supplier, whereas the typical cash gap consists of multiple payments to suppliers for ongoing customer orders. If your business is mature and growing at a conservative rate, less than 10% per year, you most likely have sufficient cash reserves or a bank line of credit to cover the cash shortfall. However, how do you close the cash gap if you are a growing business with opportunity? Oftentimes, a bank line of credit is insufficient to cover the cash flow gap for growing businesses, as bankers look back on your company’s history to determine the amount of debt they will lend you in the future. Numerous growing businesses have run out of working capital during periods of rapid growth.
Cash flow financing via account receivable factoring may be the ideal solution for businesses experiencing rapid growth. Factoring is not a loan or a debt, but the process of selling frozen assets (invoices) at a discount in order to obtain cash more quickly (typically within 24 hours of invoicing your customer). Your business sends invoices to customers and the factoring company receives a copy of each invoice. The factoring company purchases the invoice from your business, advancing 80% of the invoice’s face value. When your customers pay the invoice, the factoring company pays you the 20% reserved, less the factoring company’s fee (normally 1-5 percent ).
In the cash gap scenario discussed previously, your company’s working capital would be increased by providing cash (80% of the invoice amount) on day 9! On day 14, your business would have sufficient cash flow to make payroll; on day 30, it would have sufficient cash flow to pay suppliers and make payroll. When your customer makes payment on day 48, the factoring company remits to you the 20% held in reserve, less the factoring company’s fee.
When planning for future growth, it is critical to assess your business’s working capital requirements and cash flow gap to ensure that your plans can be realized. Utilizing an accounts receivable factoring programme can help ensure your business’s success. However, be sure to evaluate the accounts receivable program’s cost as a percentage of sales. Additionally, ensure that you are not locked into a long-term contract with the factoring company, allowing you to exit the programme whenever your business reaches a new plateau.