Short term financing tools, such as invoice finance and supply chain finance, are an excellent way to improve cash flow management and reduce the impact of cash flow interruption. However, they’re also useful as a way to generate temporary capital to drive short term growth, or to free up capital in the long term for more significant investments. Driving growth in this way comes with its own risks, however, and needs to be approached with care.
Off-balance sheet financing is, in effect, a way for businesses to finance their own growth, without relying on loans or outside investors. Understanding the limits and risks of this type of financing allows them to use it safely and quickly to finance short term growth that would otherwise be unobtainable. That means considering how to best leverage alternative financing tools, and what type of investments will best serve to drive growth without exposing the business to undue financial risk.
Finance investments with quick returns
Unlike traditional loans or investor funds, invoice and supply chain finance only provide additional funds for a limited amount of time. Supply chain finance, for example, can be used to extend payment terms by up to 90 days, while invoice finance simply brings already-earned income in sooner. By using these tools, businesses can give themselves more time with cash that already belonged to their business, rather than actually gaining new assets. They can’t, however, afford to lose those funds. Instead, any investments need to be recovered relatively quickly, so the funds can be reinvested in the business.
For example, a business might decide to use invoice finance to collect an incoming payment 60 days early. In 60 days, those funds are meant to cover payroll expenses. By collecting the payment early, though, the business now has the intervening time to attempt to generate a profit. However, it needs to be sure that any investments made pay off before its own outgoing payments are due. This means that the business needs to focus on clearly defined short term investments.
Focus on generating predictable returns
Besides keeping investments contained in terms of their time frame, businesses also need to ensure that returns are predictable. Funds that need to be recovered in time for a specific payment can’t be risked for projects that may not produce returns reliably. Search engine optimisation (SEO) projects, for example, can produce a great deal of value quickly, or they can take years to generate any quantifiable returns. This depends on a wide range of factors, many of which are unpredictable. Because of this, businesses should only invest funds in this type of project if they’re also prepared to lose them for the foreseeable future.
Instead, short-term funds should be invested predictably. That might mean, for example, using them to offer sales commissions or to pay past and current customers to refer new clients. In both cases, any money spent directly corresponds to a return, so that the capital being invested can’t simply be lost if the project is unsuccessful. Rather, the funds wouldn’t be spent in the first place.
Fully financing production to free up funds in the long term
Often, a business can combine invoice and supply chain finance to free up their current working capital for longer-term investments as well. However, that requires using these tools to fully finance their production process. This is done by eliminating the cash conversion cycle.
The cash conversion cycle is the amount of time it takes a business to convert an investment into profitable revenues. Specifically, it’s the time a business waits after paying for its inputs, until it receives payment for the products or services that those inputs were used to create. If the business can arrange it so that its payments are due only after the corresponding revenues are collected, the cash conversion cycle is below zero. In this case, the business doesn’t need to invest any of their own capital, because they can pay suppliers with the revenues that those same supplies eventually generate.
Supply chain finance can be used to do this together with invoice finance. Instead of paying suppliers directly, businesses can instead extend their payment terms to up to 90 days by working with a financial institution that will, in the meantime, extend payment on their behalf. This ensures that the payment due date for the inputs is as late as possible. Then, once a product is sold, invoice finance can be used to collect revenues immediately, often allowing the business to collect them before the inputs need to be paid for.
At this point, the capital that the business was previously using to purchase inputs for production can be invested elsewhere. Moreover, because the production process can then be fully financed going forward, investments made with that capital can be longer term in nature. In this way, alternative financing provides businesses with multiple ways to get funding for different types of investments. Knowing how they work is the key to using them effectively to grow your business, and helping it to compete.