Why is financing such a problem for today’s small and medium-sized enterprises (SMEs)? After all, hasn’t the Federal Reserve reduced the costs of borrowing money for businesses through its quantitative easing measures? Well, yes and no. While the monetary policy adopted by the Federal Reserve may have lowered the costs of borrowing for all businesses, it simply hasn’t increased access to credit for all businesses.
Undercapitalized SMEs must reduce risk by pursuing multiple financing options. Relying solely upon banks in today’s business environment won’t suffice. After all, no matter how competitive interest rates are, if SMEs can’t qualify for credit with a bank, then what’s the point? Many SMEs are asking themselves this question daily. For many of these SMEs the solution lies in pursuing alternative financing sources like asset-based lending.
The ultimate goal of the Federal Reserve’s quantitative easing strategy is to incentivize banks, credit unions, and other financial lenders into reducing interest rates within capital markets. The Federal Reserve does this by purchasing mortgage-backed securities from banks on the open market.
The Federal Reserve’s strategy is to make the interest rates paid on these purchases so inconsequential that the bank has no choice but to lend that money to businesses. For instance, it’s common for these interest rates to be no more than a quarter of a single percentage point. In this case, the bank can easily earn more than 0.25 percent by lending that capital to credit-hungry enterprises.
For the most part, quantitative easing works. However, the jury is still out as to its overall benefits for SMEs. After all, today’s SMEs must still pass stringent lending requirements with banks. What are some of these requirements?
Banks won’t advance credit unless they see an acceptable debt-to-equity ratio. Next, they need to see a history of performance over the previous five to ten years. Finally, they review the company’s financial statements, its credit rating and credit history before even considering the company’s application for credit.
Even if the SME passes these aforementioned criteria, it’s no guarantee that their limit and terms will be competitive. In fact, an SME often struggles to secure capital with a bank no matter how strong its credit rating is. This is ultimately why several SMEs are turning to non-conventional solutions like asset-based lending.
Financing is the lifeblood for businesses. Without it, a company’s risk increases. However, there are solutions to leveling out this risk that are predicated on taking a more assertive role in business financing. These solutions are based upon using the value of the company’s existing assets as collateral against capital advances.
Instead of working with banks, and their stringent tangible asset reviews, SMEs can simply use the value of existing assets in their possession in order to finance their operations. So what are some of the more common ways that asset-based lending can help SMEs reduce risk, increase their access to working capital and improve their cash flow?
Contingency planning is essential in managing credit risk. The ability to identify potential risks is one thing. However, putting strategies together to account for the unforeseen is something else entirely. It’s not enough just to be cognizant of risk. Instead, it’s about identifying current and future risks and eliminating them as concerns.
The key is to have an all-encompassing financing strategy that reduces the impact of any individual risk-driver. This is why companies are turning to readymade solutions that account for the inherent risk in capital markets. For many of today’s SMEs, these solutions involve reducing risk by using multiple asset-driven credit solutions.
Receivables Factoring: This is perhaps the most common asset-based borrowing solution available to SMEs. It is ideally suited to undercapitalized enterprises with solid sales and high value receivables. It allows SMEs to balance out the demands of corporate buyers, with their 60, 90 and 120 day open-credit terms, relative to the cash-up-front demands of their vendors and creditors.
The solution involves selling receivables to a third-party financing company. The financing company assesses the account debtor’s credit rating and history. After the account debtor (customer) is approved, the company is able to forward its receivable to the financing company the instant it generates the invoice. That receivable is used to set up a rolling credit line, one where the SME can access immediate capital. Once the account debtor clears their balance, the factoring firm credits the company the difference from the capital advance they initially received and the account debtor’s final payment.
Purchase Order Financing: Another solution involves using customer purchase orders, contracts and supply agreements as collateral against capital advances. Much like with receivables factoring, the financing firm assesses the creditworthiness of the account debtor. Next, they review the value of the purchase and advance a predetermined portion of the order’s value. Finally, a renewable line of credit is established where the company can continually draw capital in order to finance future sales.
Most purchase order financing solutions are predicated on the financing company helping the SME finance the current sale. As such, they often pay the company’s vendors and creditors on behalf of the company. However, other solutions provide more flexibility and allow the company to decide how best to use the cash advance.
Once the invoice is generated, the financing company becomes the account debtor’s point of contact for receivables collection. Again, the company is credited the difference from the original upfront cash they received and the customer’s final clearance.
Inventory Financing: This is an ideal asset-based lending option for any company that has quick inventory turnover rates. This solution allows the company to use its inventory’s liquidity in order to set up a credit line. It works when the inventory is easily sold or easily converted into cash. In fact, a number of solutions allow SMEs to secure capital before securing the actual inventory of finished goods. In this case, it’s about putting up the inventory as collateral against the cash advance.
Companies with inventories and finished goods that are easily sold across multiple markets will benefit most from this financing option. Part of the approval process involves defining the value of the inventory itself. Today’s asset-based lenders are experts in defining the value of the company’s inventory counts of raw materials, semi-finished and finished goods. High value raw materials, and easily-sold finished goods, will secure higher upfront capital advances.
When properly managed, an enterprise can pick and choose when to use asset-based financing and when to rely upon conventional financing. This allows enterprises to remain in terms with their primary lenders and creditors, while helping them to pursue customers, sales and markets they may not have had the capital to finance before.
Using multiple credit sources is critical to reducing a company’s credit risk. Using multiple solutions allows companies to balance out their cash positions and ride out the cyclical nature of their business. With asset-based financing, a company need not concern itself with limited access to credit. Instead of trying to pass a bank’s stringent lending requirements, a company can simply use the assets in its possession to finance its operations.