If they are unable to find a bank willing to finance them, many small businesses turn to commercial finance companies (CFC) for help under certain conditions. Because they demand a high amount of collateralization, CFCs will deal with companies which are in trouble. However, the cost of money from these operations is higher than from banks and much higher than from SBICs or the SBA.

CFCs make short or intermediate term collateralized loans.

For example, they may make a short term loan , i.e. a term of less than a year, using the companies receivables and/or inventory as collateral. The CFC needs to know the company=s historic bad debt ratio, and how long it usually takes to move the inventory. Once adjustments for those factors has been made, the CFC will advance up to 90% of the value of the receivables or up to 60% of the value of the inventory.

CFCs will also make intermediate term loans (up to five years) for equipment purchases. The equipment is the collateral for the loan. They will also lease equipment. If a business needs new equipment, the CFC may buy it and lease it to the company. The company must make monthly lease payments for between three and five years.

There are many advantages to leasing.

100 Percent financing--leasing generally requires little or no down payment

Preserves working capital that can be used for other revenue generating projects

Does not compromise control of the business

Lease payments are made out of pre-tax revenue, thereby creating a tax write-off as opposed to purchasing capital equipment out of retained earnings (net income, dividends paid to investors), and thereby losing important tax advantages.

Lease liabilities are generally not reported on the firms=s financial statements, thereby preserving its financial position.

Provides the ability to obtain the latest and most efficient equipment that might not otherwise be available due to financial constraints.

Facilitates the expansion or replacement of aging equipment.

Provides protection against rapid obsolescence--if property becomes obsolete before the end of the lease period, it is generally possible to trade up without much difficulty or cost.

After the lease term is complete, it is up to the leasing company to dispose of the equipment.

Factoring

CFCs can also factor (buy) receivables at a discount of between one percent to 15% depending a number of points such as:

Volumes of sales
General quality of the firm=s customers
Credit policies of the firm
The average size of an account, and
General competition among factoring firms.

Customers need not be told that their accounts could be sold.

Factoring used to be thought an extremely expensive financial tool only to be used as a last resort. However, a number of companies have entered the business and competition has lowered rates.

In addition, the factor may be assuming other chores and risks. When computing the costs of factoring, you may be able to shift the costs of bookkeeping, collection and bad debts to the factor. Factoring also provides immediate cash which may have been tied up for months, so there is a net present value computation to be made when evaluating a factor proposal.

When considering a factor=s proposal, calculate what it costs to keep those receivables on the books, the cost of collection, the cost of borrowing cash to tied you over until the receivables are collected and compare those costs with the factor=s proposed discount and then shop among other factors for the best rate. Factoring may be a useful adjunct to existing bank relationships.

Advantages of factoring

Factors will collect accounts receivables
Factors will do all the bookkeeping relative to the credit function
Factoring can be used as a supplement or substitute to bank credit when borrowing conditions become too restrictive or uneconomical
Factors will conduct credit investigations on the firm=s existing and prospective accounts. In fact, factors are experts in credit analysis. This will establish confidence in the ability to collect the accounts receivable.
Factors assume all the credit risks associated with accounts receivable.
Factors allow firms to utilize all available cash for revenue generation. Banks may require that a business maintain compensating balances on hand (ranging between 5 and 15 percent of the loan amount). In addition, certain factoring arrangements can free cash that would otherwise be set aside to meet projected current obligations.
Factoring can actually enhance a firm=s relationship with banks and other funding outlets. If lenders and investors are confident that a factoring organization will purchase the accounts receivable of a firm if the cash is needed, they will be more willing to provide assistance.

On the other hand there are disadvantages to selling all your receivables. Good customers may not like the fact that you have sold their paper. You have no control over how the receivables are collected. And you lose an opportunity to speak with a customer. Be very careful about choosing a factor.

CFCs will also help fund leveraged buyouts and acquisitions if sufficient collateral is made available.

Tom Stewart-Gordon
President, Stewart-Gordon Associates, Inc.
Editor/Publisher, SCOR Report
Dallas, Texas
January, 1996
Last updated April 27, 2000