Most businesses fail within the first five years. The risks that cause these failures are usually avoidable with a little forethought and planning. There are two broad areas that classify these risks. The first set are referred to as the “known unknowns”: all the things you know that could go wrong (the economy, for example), but you’re not sure if they will or how badly they will. The second are the “unknown unknowns”: all the things you would never have thought of in a million years. This can only be weathered if you have sufficient staying power — that’s a matter for another day. In this article we are just going to tackle the simple issue of what happens when you have to give your customer longer credit terms that your supplier gives you. This is a “known unknown” and you must prepare for it from day one.
Balancing your cash flow
Most entrepreneurs miscalculate the extent to which receiving and offering credit terms can take a damage profitability, returns and, at times, the survival of a business. If your supplier only extends you 30 days credit, and you are offering net 30 days to your customer, depending on your processing and manufacturing time, you could be out of cash for the amount of the cost of the product, for up to 60 days. On the other hand, if you deftly negotiate your suppliers to net-90 and you have net-30 with your customers, and it only takes you 30 days to manufacture, then you are in great shape because you will never be out-of-pocket for the duration of the manufacturing cycle. By the time your obligations are due, your customer would have completed payment to you. But this hardly ever happens.
In reality, if you are just starting out, you would be fortunate to get net 30 from your suppliers and if you do, the additional cost may be prohibitive. On the other side, just to get the sale, you might have to give your customers a higher number of days between delivery and payment. Sometimes as much as 120 days. While it doesn’t sound like much, there is a totally different scene going on in both these situations.
In the first case (the unlikely one) you get an order from your client which prompts you to order the necessary raw materials to make the product. If you received the order on Jan 1st and made your order the same day, your clock starts instantly. On Jan 30, you deliver your goods to the customer and now his clock starts where he owes you while your clock has already run down 30 out of 90 days. Your cash position is still zero – nothing in, nothing out. On March 1st, your client now settles what he owes you but you are only on your 60th day with your creditor meaning you still do not have to pay them anything. On March 31st your payable comes due and you now have to pay what you owe. In this scenario, you get free cash for 30 days. Remember this is not likely in the real world for small businesses, it only happens for the likes of Walmart.
In the second, more likely scenario, when the order comes in you give them 120 days credit and you order your supplies on Jan 1st. Your supplier gives you 30 days. It takes you 30 days to complete the product. On Jan 30, you deliver the product and you also pay your supplier. You are already out-of-pocket at this point. Your customer’s clock now starts, they pay you only 120 days later. All this time, you have your profits and costs tied-up.
How does this affect you? It may not be instantly obvious, but cash is king. While you have your funds tied up in the second situation, you will not be able to take on another job because if you do, in 30 days your obligation will come due and you may not have sufficient cash to pay for it. So you forgo the order. While your competitor swoops in and bags it instead.
To make the point, let’s narrate how this affects growth rates. Assuming we fund the working capital account of a company with $1. The products that a company makes costs $1 to manufacture and the profit on that product is 20 cents or 20 percent of the cost. In this case, every 120 days, the company above that’s giving 120 day terms to its customer will only get $1.20 at the end of 150 days from the day the order is taken (including the 30 day time to manufacture) At this rate, the company can only take on a customer every 120 days. In one year, that means it can only cycle its capital three times for a total return of 60 cents or 60 percent. Compare that to a situation where the timing was more favorable. The costs and profit being the same, there is no limitation on taking new orders because there is always sufficient cash flow to pay obligations since customers pay before your obligations are due. In this example if there is a new order every month then there will be a profit of 20 cents every month starting from the end of the 60th day resulting in $2 profit or 200 percent return. With nothing else changing, just the credit terms, profits take a jump.
But what’s the point of all this if the second scenario is unlikely? Well it’s true you would have to extend longer terms to customers and receive shorter terms from suppliers, especially if you are a new kid on the block. But there is a financial mechanism that will change all this. It’s called factoring.
How does factoring work?
In factoring, the bank essentially takes the purchase order that your client gives you and after some due-diligence, release a certain percentage of the purchase value to you, usually the amount you need to fund the cost of the product. This allows you to pay off your suppliers at a reduced cost since you are not expecting them to extend credit more that 2-3 days which is the time it takes the bank to process it. The cost of factoring depends on the creditworthiness of the customer, for the most part, and the ability of the client to deliver to a smaller degree. Costs will be known ahead of time, during negotiation with the Factor provider. In this situation, lets revisit the first second hypothetical scenario where you give your customer 120 days credit. Your profit ratio is still at 20 percent. Instead of waiting till your cash is unlocked 150 days after the order is first taken, you will be able to keep taking orders to the point of your physical limitation, i.e. plant size. Assuming you take an order every month instead of once every three months and your cost of the Factor is a hypothetical 12 percent p.a or 1 percent per month, your return now is calculated as follows: every order costing $1 carries a cost of 1 percent per month or 1 cent. For three months that’s 3 cents. Total cost is now $1.03. In one year total revenue is $1.2 x 12 = $14.40; cost of goods is $12 and financial cost is 36 cents. Total cost is $12.36. Profit is $2.04 meaning its a 204 percent return. That is the value of factoring.
When you are starting out on your business, one of the things most people do not realize is that they are going to have to provide some sort of credit line to customers. It is an unknown. But you get hit with it the first time your sales staff meet a customer who knows you will do anything to get his account. Setting up a factoring facility allows you to engage with those customers and win their business and hopefully, after a few cycles, their trust.