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A Way to Double Profits...

A prospective client called me the other day. He owns an importing business doing $1.0 million in sales and growing at a very rapid pace. He wanted to explore whether factoring might help him with his cash-flow crunch.

He told me enough about his circumstances-to-make-it-evident-that-he-was indeed a candidate for factoring. Then he asked about rates. I told him we could provide him factoring at a 70-percent advance rate, a one-year term contract, recourse factoring for 4 percent for the fIrst 30 days. He almost hung up on me.

He pointed out that he was operating in an extremely competitive market. "If I raise my prices by 4 percent, I'll go out of business," he said.

It was clear I had some educating to do. "Raise your prices?" I said, turning his statement into a question. "Why on earth would you do that?"

"How else can I compensate for a 4 percent cost of money?" he asked.

I urged him to stay-with-me while I asked a-few more- questions, and he agreed. I found out that his gross profit margin was 15 percent and his annual overhead cost was $60,000. Then I summarized what he had told me.

"So you're making $90,000 a year on sales of $1 million. Is that accurate?"

He agreed that it was.

My next question was to ask him how much business he could do if he had unlimited funds. He didn't even have to think about it; his response was immediate. "I would be doing $2.0 million in sales tomorrow--I'm turning away business now because I don't have the cash I need to handle it."

But if he doubled his sales from $1.0 million to $2.0 million, would that also mean he would double his overhead? Of course not. When asked, he said that extra $1 million per year in sales would only cost another $20,000 per year in overhead expenses.

The realization of how he could benefit from factoring was like turning on a light. Let's analyze this client's situation because it's a perfect example of how most business people do not understand the power of factoring.

My client was making $90,000 per year on his first $1.0 million in sales. If my firm factored 100 percent of this company's accounts receivable, his annual cost of money would be $40,000. But the increased cash flow would allow him to double his sales to $2 million.

Here's the key issue: How much will this company net after paying the factor? If it's more than $90,000, it makes more sense for this company to factor its receivables. His 15 percent gross profit margin would stay the same (actually, it should increase, since with factoring he would be able to take advantage of supplier discounts, etc., but for illustration purposes let's keep it simple) so his gross profit on $2.0 million would be $300,000. By his own calculation, his overhead cost would increase from $60,000 to $80,000. The cost of factoring is $40,000, which leaves a net profit of $180,000.

Even after paying what he thought was an unaffordable cost of money, this client could double his bottom line from $90,000 to $180,000 without incurring any debt--and without putting any more of his own money in the business!

I then asked, "So why in the world would you raise your prices if you can double your profit and keep your prices the same?"

He acknowledged that he had only been looking at the cost of factoring without analyzing the cost/benefit relationship, and that when he looked at the total picture, a price increase didn't make sense--but factoring did. Factoring would give him the cash he needed to grow his business dramatically, take advantage of the sales opportunities he was currently missing out on, and make a substantial contribution to his bottom line.

The key to this calculation is, of course, that typically as a small company's sales increase, the percentage of sales attributable to overhead decreases. In this example, the client's overhead was 6 percent at $1.0 million in sales, but only 4 percent at $2 million.

For most small businesses, a doubling of sales does not lead to a doubling of the cost of overhead. They won't need twice the office space. They won't use twice as much electricity, telephone service, or postage. And they certainly won't need twice as many employees, most business's largest expense. It's this increased efficiency, known as "economy of scale," that allows for such dramatic increases in net profit.

Even if a company's overhead increases proportionally with its sales (a rare case), it still makes sense to factor if net margins are in excess of the cost of factoring.

All too often, entrepreneurs only look at the cost side of the equation. It's important to look at the benefits side of the equation as well.