Cash is critical for firms to fund operations. However, not all income generated from sales and service provision are realized immediately, and these become the business’ accounts receivables. Like cash, a receivable is an asset, but one that you cannot use to pay employees or fund a new investment opportunity. At some point, your business may be short on money, and this is where accounts receivable factoring becomes helpful.
Factoring is selling an invoice, purchase order, or accounts receivable to a factoring company (factor) at a discount in exchange for cold cash. Factors can buy receivables for 10-50% less than their value. This type of funding is used by businesses with negative cash flow to raise funds and recover their receivables more quickly than usual. It is also known as invoice factoring and accounts receivable financing, among others.
How does it work?
Business receivable factoring involves three parties: the creditor, debtor, and the factoring company. Consider this hypothetical scenario. First, the firm delivers products or services, and the customer promises to pay $10,000 at some time. This transaction is considered the company’s “receivables.”
A few weeks after, the business owner suddenly sees a possible opportunity for investment and needs cash ASAP. He then sells that receivable to a factoring company, who pays for it in cash at a lower value, say, for $9000. Later on, when the customer pays for the products or services received, the full amount goes to the factoring company.
What are the benefits?
- Quick cash
The need for cash is the main reason why businesses sell their ARs to factoring companies. Cash is king, and without it, business operations will stall. Where else can you get quick and fuss-free funding? This money may be used to pay utilities, employees’ wages, rent, taxes, and more. Factoring instantly improves your cash flow as well as your AR turnover.
- No credit check
Since factoring is a simple sale of a receivable, no need for thorough background checks and hard-to-meet requirements from businesses. However, expect the factor to perform due diligence by authenticating the invoice or transaction.
- Working capital
Having a healthy cash flow is important to keep the business running even during low seasons and when accounts receivable turnover is also low.
- Safeguard against risk
With factoring, the business owner mostly gets rid of the risk of bad collection from the client and receives the value of the goods, earn a small profit, or incur minimal losses. On the other hand, the business factoring company assumes that risk for a bigger return.
- Pay obligations
Cash from factoring can be used to pay outstanding liabilities. This money may be used to avoid overdue balances, which improves your credit reputation over time.
- Simple process
Factors handle the processing and collection, so you won’t have to worry about anything, just make sure that the customer pays the invoice on time. The earlier the invoice is paid entirely, the earlier you’re freed from monthly fees.
What are the Disadvantages?
Factors may collect fees and some other charges for providing your cash and coming to your rescue. Factoring costs increase your losses or decrease your already small profit for selling your receivable. On the average, you pay additional fees of 3% for each month that the invoice does not get paid. Always inquire about hidden charges like termination fees, audit fees, records fees, and more.
How to find the right factoring company?
If a bank loan is currently out of the question, look for a reputable factor that has been in the business for a long time and can present you the right licenses and permit to operate. Professional factors will always furnish you with a copy of the contract, with explicit terms, rates, fees, and procedures.
Hidden costs are red flags. If you feel like a factor is milking you out of fees from selling a single invoice, then don’t deal with the same company again and go over your contract again to spot for ambiguously-worded sentences.
If you find more than one factoring company in your area, compare the rates and fees of the service. Don’t hesitate to propose a term that could work out best for all parties. Don’t enter into a contract if you know you’re going to lose out on a lot of money.
Successful factoring companies have automated services that simplify the procedure, record the payments, and provide you with reports until full payment of the invoice. Add to that, the friendly personnel whom you have access with if you need to clarify something.
Most importantly, when the customer is unable to pay, a reliable factor must work out a fair deal with you and credit your account with the equivalent amount paid by the buyer.
Factoring is a great cash source for small-and-medium-scale businesses. It provides you just the right amount of push to compensate for clients who pay slowly and to carry on business even during the lean season. It is important to keep in mind that you should only resort to factoring if you are certain to make a profit even after the process.