When a manufacturing company needs to find money, where does it go?

Traditionally, a trip to the local bank would suffice, but in today's world of higher interest rates, tighter credit standards, and increased focus on deposits, manufacturers should look at different types of financing and evaluate what is best.

This article provides an overview of different types of financing that may be available to a manufacturing company for its ordinary operations, how they work, and when they might be appropriate to use.

Traditional Cash Flow

Traditional cash flow financing relies on the company's ability to generate cash from its ordinary operations to service its debt.

While it will typically be secured by the assets of the company, the lender is not looking to those assets as its principal source of repayment.

A typical cash flow financing will contain customary representations, warranties, and covenants, and will typically include one or more financial covenants which are designed to measure the overall performance and economic health of the company.

The financing may be structured as a revolving credit loan or a term loan.

Asset-Based

In an asset-based financing, the lender relies on the liquidation value of the company's assets as its ultimate source of repayment (even though the company is expected to service the debt with cash generated from the sales of its products).

Asset-based loans are structured as revolving loans and are secured by the company's assets.

The amount which can be borrowed at any one time is determined by creating a borrowing base from the company's accounts receivable and inventory (and, in certain cases, the company's equipment).

The lender establishes criteria to determine which assets are eligible and then lends up to a discounted percentage of the value of those eligible assets.

Those percentages, known as advance rates, typically range from 70% to 85% of eligible accounts receivable, 35% to 50% of eligible inventory (with higher percentages for finished goods or other salable inventory and lower rates for work-in-process or raw materials), and 35% to 50% for equipment.

If, during the course of the loan, the company's outstanding borrowings exceed the then current borrowing base—an overadvance—the company is typically required to immediately pay down the overadvance.

In certain cases, known as "AL Lite" or "Bank ABL," the company will be able to pay down the loan at regular intervals, typically monthly.

In others, particularly where the lender is a non-bank finance company, the loan will be "fully-followed" and the company's customers will be required to pay the amounts they owe to the company into a blocked account which is used on a daily basis to pay down the loan.

Asset-based loans typically have more fees than do cash flow financings, including unused line fees, which are calculated based upon the daily unused amount of the lender's commitment.

For manufacturing companies that may have significant receivables and inventory but may not qualify for cash flow financing, asset-based loans can be an incredibly valuable financing tool, especially if they are in a growth phase.

Factoring

For many years, factoring was viewed as a financing tool of last resort, used only by companies that were in economic distress.

In recent years, factoring has become a much more mainstream financing tool for manufacturing companies, particularly those with strong and regularly generated accounts receivable.

Factoring can be used both in lieu of or in addition to either cash flow financings or asset-based loans.

Factoring involves the sale of a defined set of receivables by the company to the factor for a purchase price equal to a discounted percentage of the face amount of the receivables (typically between 25% and 30%).

As the receivables are collected (typically by the company although in certain cases by the factor), the factor retains the collected amount.

In certain cases, if the receivable is not collected, it is returned to the company and the company returns the purchase price to the factor.

Although the factoring transaction is intended to be a true sale of the factored receivables, the documentation will typically contain provisions granting the factor a security interest in the receivables it factors in case the arrangement is re-characterized as a loan.

If the company engages in factoring while also maintaining either a cash flow loan or an asset-based loan, the factor and the lender will typically enter into an intercreditor agreement in which the factor will be given priority with respect to the receivables it factors and the lender will have priority over all other assets.

Receivables Purchase

Receivables purchase financing is a variation of factoring.

This is typically accomplished through a receivables purchase agreement provided by a bank.

Unlike a factoring arrangement, which typically involves the factor buying a collection of undifferentiated receivables, the bank in a receivables purchase financing typically purchases receivables from defined account debtors and provides specific terms (including specific discounts) for each of those account debtors.

Those account debtors are typically larger entities with high creditworthiness.

Receivables purchase financings are also structured as true sales, although the agreements often resemble traditional loan agreements.

Receivables purchase financings are useful for manufacturing companies that sell to larger customers whose receivables would be considered more "financeable" than those of smaller customers.

If the company enters into a receivables purchase agreement while also maintaining either a cash flow loan or an asset-based loan secured by its receivables, the existing lender will have to release its liens in the receivables being purchased.

Discounted Payment Arrangements

Some large purchasers have instituted discounted payment arrangements for their manufacturing company suppliers.

This can be done either directly or through third parties.

The core of this arrangement is that the manufacturing company agrees to take a discounted payment (often around 10%) on its receivables from that purchaser while the purchaser guarantees that the receivables will be paid within an agreed period of time, typically 30 to 60 days.

Again, if the manufacturing company also maintains a cash flow or asset-based loan secured by its receivables, the existing lender will have to release its lien on the receivables which are subject to the discounted payment arrangement.

While no one likes to accept a discount on payments up front, these arrangements can be particularly valuable for manufacturing companies that want to maintain a steady and predictable cash flow and particularly if the customer has a history of stretching payments.

Inventory

Inventory can be costly to both purchase and maintain.

Many lenders both large and small, will provide financing using the company's inventory as collateral.

Inventory financing typically takes the form of a term loan, although occasionally it takes the form of a line of credit.

Inventory financing is typically best suited for companies that either maintain or purchase large amounts of inventory.

Purchase Order

Many manufacturing companies need cash to pay for supplies or materials that they need to fulfill purchase orders.

This can be particularly concerning in connection with a large purchase order where a significant cash outlay is needed.

In a purchase order financing, the purchase order lender, which is typically a specialty finance company, finances the costs of the purchase order by paying the supplier directly.

The receivable associated with the order is assigned to the purchase order lender, and the customer pays the purchase order lender directly.

The purchase order lender takes out its fee and sends the difference back to the company.

Purchase order financing is a useful tool for manufacturing companies that have large, cash-intensive purchase orders.

Vendor

If a manufacturing company is looking to purchase equipment, particularly if it is large or expensive, vendor financing can be a useful tool.

Essentially, the maker of the equipment finances the purchase either through loan (secured by the equipment) or a lease.

Merchant Cash Advances

Merchant cash advances have become increasingly popular over the last few years, particularly among companies whose customers purchase largely by credit card.

The MCA provider provides cash to the company and lends against the company's future sales.

There are many types of MCAs, some of which are secured by the receivable associated with the credit card purchase and some of which are unsecured.

In all cases, the MCA provider receives a percentage (often between 20% and 30%) of the company's sales revenue.

MCAs are an expensive financing tool. Because the industry has historically been largely unregulated, MCA's have had many unscrupulous providers give the industry a bad name.

MCAs are not well suited in general to manufacturing companies, and those companies should be wary of attempts to "sell" them on MCA's.

State Grants and Loans

Finally, many states, including Connecticut, have agencies which provide grants and/or loans to support business growth or the acquisition of equipment or inventory.

In Connecticut, those agencies are the Department of Economic and Community Developmentand Connecticut Innovations.

Since the goal of these agencies is to promote job growth in Connecticut, the grants or loans will typically contain specific job creation/retention goals and targets and will also contain penalties if the company moves out of the state.

While these loans or grants can be more expensive than traditional bank financing, they are often a good complement to bank financing (often the DECD will lend against equipment while a bank provides a revolving credit loan and the two will enter into an intercreditor agreement) or, if the company is having trouble lining up bank financing, a good "lender of last resort" to help the company grow to a point where it can obtain bank or other financing.

In summary, it is important for manufacturing companies to understand that, while bank financing is preferable, there are plenty of other potential financing sources available to them depending upon their particular needs and general economic condition.

This article first appeared on CBIA's website and is published here with permission.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.