When Cash Flow Lags, a Factor Can Help or Hurt

If you run a business, you know better than to expect smooth sailing all the time. Sooner or later every business hits rough water, and when it happens you learn that sometimes success depends not on how you make the most of good times but how you manage bad.

And if your trouble has to do with cash flow, you face a delicate question: how to solve your short-term problem without damaging your long-term prospects.

Hector Navarro faces exactly that dilemma in running his Commerce company, Extension Plus Telecom Inc., which installs and services business telephone and electronic communications systems. The strategy by which he hopes to overcome it contains a valuable lesson for anybody who owns a business.

Navarro’s biggest customer is the Los Angeles Unified School District, which like many other public agencies can take 90 days, sometimes longer, to pay an invoice. This, of course, puts a crimp in Navarro’s cash flow. He can’t delay payroll, for example, until the LAUSD whips out its checkbook. Nor can he keep his suppliers or the Internal Revenue Service happy on the LAUSD’s schedule.

To overcome this difficulty, Navarro has decided to resort to factoring some of his LAUSD receivables--at the risk that the interest costs of the technique will eat him up.

A financing technique almost as old as trade itself, factoring allows you to raise working capital with relative ease, but it is among the most expensive types of financing you can use, and if you don’t keep on top of it, it can ruin you. This is not to argue that factoring is a bad idea or that factors prey on the vulnerable business, but rather that factoring is a risky technique--though useful in the right circumstances.

In the old days, you sold your receivables outright to a factor who shouldered the risk that some or all of those receivables would prove uncollectable. The factor compensated for this risk by buying your receivables at a discount--often a very deep discount. Factors fueled trade between England and its American colonies before the War of Independence, and it remains the financing technique of choice among such industries as apparel.

These days, factors still buy receivables at a discount, but they don’t always buy them outright. Many structure their deals so that, if they don’t collect on a given receivable after a certain time, you must return the advance with interest.

In effect, this makes you the factor’s partner in collecting on your receivable, and that makes it very necessary that you use factoring only when, like Hector Navarro, you don’t have many alternatives.

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Navarro launched himself as a solo installer of telephone networks on Dec. 31, 1985, at the age of 19. He got work from a friendly Beverly Hills general contractor, and after he married and started a family, he made ends meet by holding down two other jobs--teaching a night school class in telecommunications and driving a forklift during the graveyard shift. Some nights he got by on as little as four hours of sleep.

Now he has 22 employees and expects revenues to hit $1.1 million by the end of this year. More than 30% of his revenue, however, represents work done for LAUSD, which means good news and bad news for Navarro. The good news is that the LAUSD is a solid customer. The bad news is that it pays its bills slowly.

Navarro began winning bids to help the district wire its classrooms for the computer age last year, and he took on additional employees and bought supplies to handle the workload. Thus his payroll and accounts receivable ballooned, but his cash flow didn’t keep pace.

Navarro always made payroll, and he kept his suppliers friendly by putting them second in line behind his employees. But he began letting his quarterly payroll tax payments to the IRS slide. The IRS, wanting none of that, hit Navarro with a lien, including something like $8,000 in interest and late charges.

The lien, of course, made Navarro unbankable, so he stood no chance of digging himself out of the hole with a loan for working capital from a commercial bank. To a factor, on the other hand, it’s your customers’ credit ratings that count, and receivables from public agencies generally look like quality goods to factors, even if they are slow to pay.

So Navarro cut a deal with a commercial finance company, Real Capital of San Clemente, to factor some of his LAUSD receivables beginning this month.

“I want to continue to grow,” Navarro says, “and I have to minimize the effects of late payments to the government. That $8,000 could have gone to something productive like maybe equipment or training for my employees.”

Navarro’s deal with Real Capital calls for the finance company to advance 70% of the face amount of an LAUSD invoice and deduct interest costs from the balance, when received. The company will charge Navarro 3.9% of the invoice amount for the first 30 days, 1% for each 10-day period thereafter. And if the LAUSD doesn’t pay the invoice in 90 days, Navarro must buy back the invoice by returning his advance plus interest.

Thus, assuming an invoice for $50,000, Navarro will get $35,000 in working capital upfront, and if the LAUSD pays the invoice within 30 days, he will receive another $13,050--that is, $15,000 less $1,950, which is 3.9% of $50,000. If the LAUSD doesn’t pay for 60 days, on the other hand, Navarro’s interest costs climb $1,500.

They go up an equal amount if the LAUSD doesn’t pay for 90 days, and in addition he must buy back the invoice for his original advance. Worse, he will owe Real Capital $4,950 in interest, so that when the LAUSD finally does pay, he will net $45,050.

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No matter how you look at it, that makes factoring an expensive option, but in Navarro’s eyes, the alternatives are worse.

“I can’t get bank financing for my receivables because of the tax lien,” he laments. “I’m going to factor some of my LAUSD receivables because I need to play catch-up--pay off the tax lien and get it off my record.

“Maybe I’ll incur $3,000 to $4,000 in finance charges--but if I continue not paying my taxes on time, the $8,000 could double. I have no other choice. I need cash flow to feed the business.”

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Juan Hovey can be reached at (805) 492-7909 or at jhovey@gte.net.