Accounts Receivable Factoring for Small Business
Accounts receivable factoring acts as a way to speed up cash flow. A factor buys your invoices, paying your company upfront and validating your customers’ creditworthiness. With cash flow being a common issue for a lot of small businesses, this can be a huge relief and prevent businesses from facing the disastrous consequences of running out of cash. The SME Toolkit describes the basics of factoring here. We present all you need to know about accounts receivable factoring for small business.
What is Factoring?
Factoring refers to the process of selling your accounts receivable invoices to a third party who then performs the function of collecting the invoice. Called factors, these agents can move quickly to get funds to a business for a fee as a means of providing financing for growth. Most factors initially pay you in two stages; the majority (70 to 90%) up front on the initial advance and the balance when the invoice is collected, through the reserve release . Factoring fees range from 2% to 5% or higher depending upon a number of variables (see factoring fees).
Why (and when) factoring?
Cash flow is king in a business!
80% of business failures can be attributed directly to a lack of cash flow and/or working capital. A business may be growing leaps and bounds, but if monthly sales invoiced do not produce cash on time to pay wages or creditors, it may still fail from being cash starved.
Factoring allows a business to sell invoices to a third party, a factor , at a discount in return for cash advanced before the invoice comes due. In addition to the benefit of having cash on hand sooner to support operational expenses and growth, factoring does not usually tie up assets outside the business, does not involve the repayment of debt at some future point in time or if called on a certain date, and frees up internal resources normally devoted to tracking and collecting Accounts Receivables.
Factoring can be an attractive tool for many businesses but may be most appropriate for rapidly expanding operations. For example, it takes time to get an increase in a traditional bank line of credit. However, time is usually of the essence when a large order is received and requires additional financing for raw materials. Other less routine situations include; management buy-outs, acquisitions and restructures, turnarounds and delinquent tax situations. Business start-ups that have sufficient accounts receivable volumes and sales turnover levels will also find factoring a valuable financing tool.
While there is a cost to your business when you factor , this cost, or a portion of it, should be built into the cost of sales and/or be justified in terms of the value that the advanced cash on hand represents to your operation. Often businesses are able to increase prices or take advantage of supplier discounts and benefit from the enhanced purchasing power the additional capital provides them. In general, the following variables determine factoring fees:
- Risk: refers to the credit worthiness of the account debtors (your customers).
- Maintenance: refers to the work involved in managing your receivables. In other words whether you have a large number of small invoices or a smaller number of large ones.
- Time: refers to how long your customers take to pay. Time is money after all.
- Volume: plainly stated means the higher the volume the lower the fees.
Any Factoring company that quotes you a rate without knowing all the particulars of your business is doing you a disservice and wasting your time. There are details that will not only determine the best factoring rate but also the services required to ensure its success. If factoring does not solve the problems it was intended then the expense would be much higher than anticipated.
Factoring fees do not vary much from factor to factor but they are often presented in radically different ways. They can be stated as; a one time off the top discount fee, a daily discount rate or even as a fee with a rebate. Clarity and track ability are important issues to consider. The end result should be a discount off the invoice similar to the merchant fees that credit card companies charge to their retail establishments.
Some innovative factoring companies have developed Asset Based Lines of Credit that incorporate the best of factoring (full accounts receivable management) and a line of credit (low rates charged only on the money borrowed). Qualifications would typically be higher. Fees are split between a Collateral Management fee and an interest rate on the monies borrowed.
Qualifying for Factoring
The following characteristics are viewed when a business is evaluated as a factoring client:
- Businesses owner’s knowledge of and experience in their industry
- The credit worthiness of the businesses customer base, and
- The strength of the businesses receivables
Factoring vs. Bank Financing
Factoring can be a valuable alternative for securing vital working capital, when a bank may be unable to provide financing due to some of the following situations:
- Start-up business with a limited track record
- Rapid growth drives consistent increased capital needs
- History of operating losses
- Minimal or deficit net worth
- Tax liens in place
- Past personal/business bankruptcy or credit issues
Banks operate with tighter credit parameters due to the fact that they are operating with depositors funds or borrowed funds from the Federal Reserve. It is this fact that requires them to be more conservative with their lending practices.
Improve Your Cash Flow with Factoring
It may cost a little upfront, but the benefits of having cash immediately are numerous. If you’re having cash flow issues, accounts receivable factoring is definitely something to consider. If you’re not, consider the value of having money available to you earlier compared to the cost of factoring. It’s not right for every small business, but for many, it could pay off.