Bank loans can serve a valuable purpose in the creation of a new company by helping bridge financial gaps. However, bank loans carry a high risk. The company puts up its very assets and ability to stay in operation as collateral. If a company defaults on a bank loan payment, it can possibly be shut down. Due to this risk, many companies of all sizes seek to avoid bank loans as often as possible. One method employed by many businesses is factoring and purchase order (PO) financing. Factoring and PO finance both leverage an organization’s accounts receivable to immediately receive funds. Many small and large organizations have figured out how factoring and PO finance can eliminate the need for bank loans.
A Brief Introduction to Factoring and PO Financing
Factoring and PO financing are both methods of garnering funds that completely avoid obtaining bank loans. According to a survey conducted by the U.S. Small Business Administration, 50 percent of small businesses fail within the first five years of operation. Michael Ames, author of Small Business Management, lists three of the primary reasons these companies fail as:
- Insufficient Funds
- Lacking Proper Inventory Management
- Undesirable Credit Arrangements
Ames suggests companies are often unprepared for the cash gap caused by large business-to-business transactions. He also suggests that many companies are unprepared to receive large orders and end up unable to fulfill the purchase orders. In both situations, companies can be tempted to seek a bank loan. However, PO finance and factoring can help solve these issues. Below is a brief summary of these two business-saving financing options:
- Factoring – According to Entrepeneur.com, factoring is: “a financing method in which a business sells accounts receivable at a discount to a third party funding source to raise capital.” Entrepeneur.com further states that factoring is for use in business-to-business or business-government transactions. In both of these situations, large orders are fulfilled without receiving payment up front. Invoices are then sent and fulfilled within 30, 60 or even 90 days. This can leave the supplying company with a cash gap between when they provided the product or services and when they receive payment. This is particularly applicable to certain industries and there are specific types of factoring like invoice factoring for freighters, who can get paid for completed deliveries sooner.
This cash gap ties into the aforementioned “insufficient funds” and “lacking proper inventory management” reasoning behind business failure. An unprepared company can be without working capital until the invoices are fulfilled. However, with factoring, the supplying company can sell these invoices to a factoring company. According to the Wall Street Journal, these financial institutions will pay anywhere from 92-94% of the invoices face value. The remaining percentage is their fee. Entrepeneur.com states that factoring institutions will typically pay 75-80% of the amount up front, and the rest once the invoices are collected upon. This immediately provides capital and allows companies to continue to operate—all without bank loans.
- PO Finance – According to Investopedia, PO finance is the process in which a company assigns purchase orders to a third party, such as 1st Commercial Credit, in order to gain immediate capital and fulfill their purchase orders. Purchase order financing companies issue a Letter of Credit that allows the company to fulfill the purchase order. Payment is then made directly to the PO finance company, which then transfers payment back to the requesting company, less a percentage fee. This allows a company that is unable to fulfill a large order with its own capital to service the order and make a profit, instead of turning the order away.
How Do They Eliminate the Need for Bank Loans?
Factoring is the direct sale of an item: invoices. PO financing provides a Letter of Credit to allow a purchase order to be fulfilled. Neither situation provides a bulk sum of money that requires payment. The only collateral is the invoice or purchase order itself, not the company’s assets. Conversely, a bank loan provides a set amount of money with an interest rate and is required to be paid back. Bank loans are typically sought when a company is experiencing a cash gap or shortage of funds to fulfill an order. By leveraging invoices and purchase orders in these situations, companies can entirely eliminate the need for bank loans.
Guest article written by: Ray Franklin is a contributing writer who owns and operates a textile company. He has successfully used alternative methods of financing to avoid bank loans for the past seven years, allowing his business to grow and gain more financial independence.