Staged funding is not a requirement, part 2

In the last post, we left you hanging with the assertion that staged funding is not a requirement to do business in our niche.  Before we can show you why, we need to quickly go over a couple of financial analysis and commercial banking topics.

Opportunity Cost

This question is one of trade-offs.  When evaluating trade-offs, it is important to understand the concept of opportunity cost.  Opportunity cost is:

The cost of an alternative that must be forgone in order to pursue a certain action. Put another way, the benefits you could have received by taking an alternative action.

In order to establish the opportunity cost of staged funding, we need to determine what the alternative is.  When a contractor orders product to install for a consumer, that can happen in one of several ways.  The contractor might run down to The Home Depot and buy materials at the Pro Desk and could pay for materials out of pocket.  More frequently, the contractor will have a relationship with a supplier for their product line.  In this case, payment for the product could be due on a net 10 or net 30 day basis, which is typical for trade credit.  If the contractor has to pay out of pocket, or if the job is going to take longer than the terms available for the supplier, the contractor must use working capital.

Working Capital

Working capital is best thought of in this discussion as:

the difference between current assets and current liabilities. Current assets are the most liquid of your assets, meaning they are cash or can be quickly converted to cash.  Current liabilities are any obligations due within one year.

If the company doesn’t have current assets (cash) available, then the best way to generate working capital is through short-term credit.  This usually comes in the form of a business line of credit from a commercial bank.  Business lines of credit are used for short-term debts, not for long-term debts.  There are often requirements that the lines are “rested” annually (brought to a zero balance).  And having a working capital line of credit is very, very commonplace.

So, before we do a little math, let’s establish a proposition that is both reasonable and the simplest way to look at this.  Whether a contractor uses out of pocket working capital or advances funds from a business line of credit for that purpose, the cost of the business line of credit is a good estimate of the opportunity cost of (alternative to) staged funding.

Doing the Math

Here’s a scenario for our analysis: you sell a job for $10,000 that takes 30 days to install.  Because of the nature of your business, you have to pay 50% of the job amount immediately.  In one case, you use staged funding from your consumer finance partner to cover that working capital need.  In the comparison case, you get an advance on a business line of credit.

Just a couple more pieces of information are necessary:

  • First, the consumer finance partners offering you staged funding charge you to access it.  This charge is either part of a fee for the loan product selected or the cost of the card swipe to get paid by credit card.  We will be conservative and estimate this cost at 2.0% of the job amount.
  • Second, the business line of credit carries an interest rate of 6.0%.  This is a middle of the road rate and the equivalent of a daily rate of 0.0164%.

Therefore, the total cost to you in this scenario to access staged funding is $10,000 x 2.0% = $200.  True, you may get more than staged funding for that 2.0% cost, but you also can’t have staged funding without the 2.0% cost.  And there are financing options (us, for example) that come with no cost to you.

Compare that to the total cost of the business line of credit, which is $10,000 x 50% of the amount x 0.0164% daily interest rate x 30 days = $24.60.

So there you have it.  Staged funding costs you $200 and the line of credit costs you $24.60 to produce the identical result: working capital.  This is why staged funding is not a requirement to do business in the home improvement contracting niche.

One comment

  1. […] Read Staged Funding is Not a Requirement, PART 2 here. […]

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