Extending credit is a great way to encourage sales. But while you wait for the customer's payment, you have real needs for that cash: inventory must be replenished, overhead costs aren't on layaway and need to be paid, and employees expect their paychecks at the same time every pay period. But where will the cash come from?
Factoring is selling the value of what your customers owe you before they pay it
Let's say you've made the sale and the customer has taken possession of your product or service, agreeing to pay you for it in a specified time period. You enter an accounts receivable entry in your business's books, awaiting the payment.
Factoring is the sale of accounts receivable, as opposed to borrowing against them as you would do in accounts receivable financing. By selling your invoices, you generate cash immediately instead of having to wait for your customers to pay you. This can be beneficial to your cash flow situation.
The seeds of the modern factoring industry were sown in the 15th century, that hectic era of Joan of Arc, the birth of the Ottoman Empire, the War of the Roses, and--who could forget?--Columbus' discovery of America? Factoring evolved along slightly different paths in Europe, Britain and America, so the 21st century version described in this article refers specifically to factoring American-style.
Accounts receivable
Accounts receivable represent sales that have not yet been collected as cash. In the worst-case scenario, unpaid accounts receivable will leave your business without the necessary cash to pay its bills. Accounts receivable also represent an investment, which means the money tied up in accounts receivable is not available for paying bills, paying back loans, or expanding your business. This can all be summed up as a lack of liquidity. Your business can make a substantial profit but still suffer illiquidity. Got constipated cash flow. . .? No worries. . . call a factor!
Commercial finance companies, some banks, and a variety of other types of financial companies will often factor receivables. For businesses with relatively small accounts (e.g., less than $10,000), it may require some effort to locate a factor company willing to purchase low amount receivables.
The good news is that the factor company that purchases your receivables takes title to the invoices and collects them when they are due. That company also assumes responsibility for all of the costs, as well as the hard work and hassle that comes with customer debt collection.
The bad news is that factoring is not cheap; the cash price of the accounts receivable is rather heavily discounted by the factor company. Factoring is generally used by rapidly growing businesses that face temporary cash flow problems. Except in certain industries, factoring is not generally used on a long-term basis.
Factoring advantages
The advantages to factoring include:
- Quick cash. You can receive quick payment in cash after the time of shipment, delivery and invoicing a customer. If a relationship with a factor already exists, turnaround on the sale of receivables should take only about 24 hours. When making a first-time purchase of invoices from a business, factors typically take one to two weeks to check the credit ratings of the customers and communicate a discount price.
- No debt. Factoring is a sale of assets (invoices), not a loan. For businesses that either cannot qualify for traditional debt financing or that simply do not want to incur more debt, factoring is good alternative means of financing.
- Elimination of collections. Most factoring is called "non-recourse," meaning that the factor company purchases all rights in the invoices and the seller has no responsibilities for collection. The factor's anticipated cost and time in making collections is computed into the discounted purchase price of the receivables. In some states, however, "recourse" factoring is also permitted. In recourse factoring, you are secondarily liable for any invoices not collected. The factor company undertakes debt collection, but you remain ultimately responsible to repay any portion of the cash price attributable to an account that went uncollected.
Factoring disadvantages
The disadvantages to factoring are:
- Cost. Traditional loans will typically be less expensive than the costs of factoring. The upfront cash price for accounts receivable is typically 70 to 90 percent of face value, depending upon the credit history of the customers and the nature of your business. The initial price is treated as a cash advance and you typically receive an additional portion of the face value when (and if) the accounts are collected. Your final price is usually from 90 to 95 percent of the original invoice amount. The longer the invoice period, the higher the rate. Most factors will not take invoices with longer than 90-day payment periods. In addition, the credit history of the customers can affect your final costs. While a 5 percent cost may not seem particularly expensive, remember that most invoice cycles are only 30 to 90 days. Paying a 5 percent discount, once a month, for factoring an average 30-day invoice amount of $10,000 is the equivalent of a 60 percent annual percentage rate.
- Possible harm to customer relations. Collection actions taken by the factor company may endanger an ongoing business relationship with one of your customers. In a small business, there may be circumstances in which you would compromise a debt, extend payment deadlines to a preferred customer, or employ a more lenient collection approach for a specific customer. A factor company has little interest in preserving your future relationship with the debtor and some companies may be overzealous in collecting receivables.
Factoring agreements can be quite flexible, and you should always try to negotiate for the best terms possible. Renegotiation for a lower discount percentage is common in ongoing factor relationships; however, the most negotiable charges are often not the initial discount percentage, but other additional charges (such as a fee for expedited wiring of your cash price or an initial user fee) assessed by most factor companies.
As an alternative means of filling a short-term gap in cash flows, factoring can be an effective--albeit sometimes expensive--solution. One way to be in a strong position to negotiate with a factor is to plan ahead and anticipate your cash gaps so you’re not ambushed by a crisis.
If a cash flow crunch does happen, remember that you have options. And factoring is an overlooked one.