Running a small business is stressful. One of the biggest sources of stress & frustration is poor cash flow due to the inability to collect invoices on a timely basis.
In my dealings with small business owners, cash flow struggles are a major issue. Therefore I wanted to share information about factoring.
If you’re looking to get your cash flow back on track again to improve the health of your business, then factoring receivables may be a good idea for you. This service can be an optimal solution for a business looking to fill short-term cash flow crunches and those who need quick & easy funding for growth.
In this article, I’ll discuss how to free up your cash flow with receivables factoring, when to do it, how it works, benefits of invoice factoring, and an example of how it works.
What is Account Receivables Factoring?
Let’s start out with what it’s not – getting a loan.
Also, it’s not invoice financing. With invoice financing, companies want to advance you a certain amount of cash based on the value of your receivables. Then, once your customers pay up, you pay back your loan, plus fees and interest.
Rather, factoring receivables occur when you sell your business’s outstanding invoices to a financing company for a discount. Through factoring, they will buy your business’s accounts receivable for a discount and then collect your customer’s payment.
Overall, the main difference between factoring receivables and invoice financing is that invoice financing companies don’t take on the debt or responsibility for collecting the invoices.
Examples of Factoring Receivables For Cash Flow
To get a better idea & a clearer vision of how factoring your accounts receivables can benefit you & your company, here’s a real-world example:
Let’s say you have $100,000 on an outstanding invoice with 30-day terms.
In this situation, all too many small business owners are too busy running their business to collect their outstanding invoices and they start to fall behind on their cash flow, which puts them in an unfortunate cash crunch.
This situation is where using a factoring company can come in handy because they can buy your outstanding invoice, for example, 85% of the invoice value and holds the remaining 15%. This means that you’ll see $85,000 in your bank account instantly while the lender keeps $15,000.
The factoring company charges you a 3% processing fee, or $3,000. It takes two weeks for your customers to pay up, so you end up paying a 2% factor fee—or $2,000. The lender keeps $5,000 of the $15,000 reserve, and you’ll get an additional $10,000 back.
The discount at which the factoring company buys the outstanding invoices will be the cost of funding.
Can you see how factoring receivables can help you get out of a cash flow crunch without going into debt?
When To Use Factoring?
Factoring receivables can be ideal for businesses that have long net terms but have ongoing operational expenses or new expenses that help propel growth.
- experiencing cash flow shortages due to a slow turnover in accounts receivable
- fast-growing companies whose past earnings and sales histories will not justify traditional bank loan financing
- start-up businesses with no financing base
- principals with good or bad credit and cannot obtain traditional financing
- Export Trade Finance
- Medical Providers
- Oilfield & Gas
- Service Providers
- Security Guard Companies
- Trucking & Freight Brokers
Benefits of Factoring
Account receivables factoring will have different benefits for different businesses. In some cases, a business loan may be better than factoring. Before committing to a factoring agreement, weigh the pros and cons of invoice factoring. Here are some of the benefits:
- Fast Access to Capital – You might need to finance a new business opportunity quickly or cover unexpected costs. Traditional financing takes a long time and can cause you to miss out on opportunities. Also, if times are tough, banks are less willing to lend.
- Factoring Can Build Your Credit Profile – Factoring can help businesses, especially younger ones, build (or rebuild) a positive business credit history. Not all factoring companies report to the credit bureaus, so if this is important to you, make sure to ask.
- Easy To Qualify – Since you are using existing invoices as collateral, it’s quicker and easier to obtain approval (in many cases within 24 hours).
- Factoring Can Help Companies Survive A Downturn – Every business goes through cycles and during these down times, traditional finance companies are more reluctant to lend to businesses when the going gets tough. Factoring companies, however, are more concerned with the creditworthiness of a client’s customers, and not just on the strength of the client itself, which is why receivables companies are a reliable source of capital in tough economic times.
Costs of Factoring Invoices
Invoice financing costs largely depend on three factors:
- Rate: Most factoring fee rates range between 0.5% to 5% of the invoice amount per month. The fee rate is usually determined by the quality of your customers, the number of customers you have, your industry, and your business financials amongst other things. As a general rule of thumb, the more invoices you factor, the lower your fee rate tends to be.
- Service Length: The length of your net terms also comes into cost consideration. The shorter the time you take out financing for, the cheaper the total fee since fee rates are charged in percentages on a weekly or monthly basis.
- Additional Fees: Even if you are offered a low fee rate, you should be on the lookout for any additional fees that may be outlined in your factoring agreement.
Challenges With Invoice Factoring
While getting advanced payments on your outstanding invoices can be a business-saving event, there are some concerns with factoring receivables:
- Giving up a portion of your profits – With factoring, you can get access to money in a hurry – however – fast cash is expensive. You’ll have to decide if higher upfront fees is worth the speed of receiving funding fast.
- Your clients will know you are Factoring – When you introduce a 3rd party into the equation, especially to your customers, it sends a signal that your business may be struggling. This is mostly ego, but if it’s something you’re uncomfortable with, you need to take that into account.
- Slow paying customers will cost you in fees – Many factoring companies will charge up to a point a week on collections, so if you have slow paying customers that take 6 weeks to pay, for example, that can cost you an additional 6%.
How To Get Started With Factoring
Again, I’m not a factoring company nor am I affiliated with one but typically for any factoring company, you can follow 4 simple steps:
- Apply online – Enter basic details about your business and customers.
- Get approved – Company will review your application and reach out with a decision in as fast as 24 hours.
- Submit an invoice – Upload invoices to the company’s website
- Get your advance – Get paid according to the terms
Again, in comparison with a loan application process or something of the like, this process is much quicker and less invasive.
Summary of Factoring Receivables
Factoring receivables can be a fast and effective solution to your cash flow stress and/or allow you to grow your business without going into crippling debt. However, before leaping into an invoice factoring agreement, read all the fine print, use a calculator to determine all the costs, and make certain that this financing solution will improve your situation and provide long-term business success.