What does it mean when a company claims to be operating in a demand-driven industry? After all, isn’t it the same as operating in any industry, one where a company responds to the demand of its market and the needs of its customers? Well, yes and no. A demand-driven industry is one where a company’s production is driven by the specific demand emerging from its market. In this case, it’s often a situation where companies manufacture customized products, ones tailored specifically to a customer’s unique requirements. Unfortunately, financing manufacturing in this type of industry is incredibly costly as companies struggle with a high cost of capital and the constant issues posed by poor cash flow. The problem is made worse by a lack of viable credit sources. In fact, a demand-driven industry simply isn’t conducive to bank financing. However, receivables factoring is an ideal solution for those manufacturers that simply can’t rely upon financing from a bank or credit union.
Why does it cost so much to finance a company’s operations within a demand-driven industry? Well, for one thing, customers that purchase in this type of industry are known for multiple change requests, the kind of requests that often require a complete redesign and requests that invariably put a temporary halt on production. In the end, it means companies that manufacture customized products must finance their operations and manufacturing for longer periods. In this case, their costs increase the more often a project or order is put on hold. The longer it takes to finish that product, the higher the company’s costs to finance its manufacturing and operations. These delays impact the company’s cash flow, and the company’s poor cash position increases its manufacturing and purchasing costs. So why aren’t these companies able to use financing from a bank or credit union?
When thinking about a company operating in a demand-driven industry, think about that company’s cash flow statement, its balance statement and its income statement. Think about how all three are used by today’s banks and credit unions when performing their risk assessment on the company. Think about how these banks and credit unions insist upon three to five years of solid performance before agreeing to advance the company capital. Think about how difficult it’s been to generate solid returns in this economy. Now think about how the majority of today’s enterprises aren’t able to meet these aforementioned criteria.
A company operating in a demand-driven industry is one whose cash flow statement is guaranteed not to pass a bank’s criteria. It’s simply a matter of the market the company operates in, one where customers delay orders, put holds on orders and one where those delays and change requests directly impact the company’s cash flow. In this case, it’s less about how the company itself is performing and more about how the company’s market and industry is performing. At the end of the day, it’s the market itself that a bank or credit union repudiates. In many instances, it’s the market itself that represents the biggest risk, not the company or its customers. It’s the difficulty of financing a company in a demand-driven industry, one in an economy that is only now starting to rebound. After all, regardless of how low interest rates are in today’s marketplace, a company’s financing will increase when it is asked to hold orders indefinitely. However why do these financing costs increase?
In order to answer that aforementioned question, it’s important to understand what impact these delays have on a company’s costs of capital. Every manufacturer finances its inventory, its purchases of raw material and its production by borrowing capital from either a bank or credit union. In this case, the company must pay its vendors and its creditors, all the while paying salaries to employees and covering manufacturing costs, long before it gets paid by its own customers. The longer it takes to collect from customers, the higher the financing as the company is unable to pay to cover its purchases and labor costs. Instead, it must continue to borrow money and cover a daily interest rate to borrow that money. Therefore, every change request means another delay in invoicing and consequently, another delay in collecting on a receivable.
In order to understand how receivables factoring can help companies in demand-driven industries, it’s important to review how this particular asset-based financing tool works. Much like the name implies, receivables factoring means using a company’s receivables in order to set up a credit line with a financing company. However, it’s not a credit line that is set up on just one unpaid customer invoice. Instead, it’s a rolling credit line, one where the company is able to use multiple receivables in order to secure the working capital it needs to finance its operations.
Receivables factoring is but one of many asset-based financing solutions. These solutions allow companies to use the liquidity within their inventory, their purchase orders and contracts, in addition to the value of any of their real-estate holdings. However, receivables factoring is a more popular solution. After all, regardless of whether a company provides a product or a service, it is guaranteed to invoice its customers. So how does receivables factoring work?
In order to establish the credit line with the financing firm, the company would forward all the information about those specific customers it wishes to use factoring with. The information would include the name of the company, its address, its payment history and the amount of business the company does with its customer. The financing company would then review the account debtor’s credit rating. In this case, the financing company isn’t concerned with the company’s credit rating; it’s concerned with the credit rating of the customer who owes on the invoice. If the company’s customers have demonstrated a solid history of paying their invoices, then the financing company will immediately establish a working credit line.
When the company generates an invoice for one of its approved customers, it must send that invoice directly to the financing company. In return, the company receives an advance against the value of their receivable. This advance is typically 85 to 90 percent of the total value of the receivable. This transaction means the financing company is responsible for collecting on the receivable from the company’s customer. Once the customer pays the financing company, the financing company reimburses the company the difference between the advance and the final payment.
The fees for factoring are fairly straightforward that involves a discount fee based on the value of the invoice.
Receivables factoring is ideally suited to demand-driven industries, ones where companies require immediate financing in order to cover their costs of operations and manufacturing. In this case, receivables factoring improves financing for manufacturers of custom-made products because it helps them to reduce the impact of any single delay on a given purchase order. When customers make changes to designs, it immediately puts a halt to production. These temporary changes means a company must still continue to finance its operations. Ultimately, this increases the company’s financing and makes it more difficult to maintain a positive cash position. However, using receivables factoring allows them to tap into credit immediately, without having to wait for that day when they finally collect on a receivable.