In order for any business to be successful, it is important to have distinguished cash flow. Defined as the movement of money into and out of your business, cash flow determines your business’ solvency. Without sufficient cash flow, your business is likely to fail. There is a way to get funding and improve your cash flow without heading to the bank. This little-known solution has been around for years, and pushes lending and borrowing to the side. The solution? Factoring.
What is Factoring?
Factoring is the process of selling accounts receivable to an investor rather than waiting to collect the money from the customer. In simpler terms, factoring is a financial tool that allows businesses to get their invoices paid in as little as two days. Factoring deals exclusively with business-to-business transactions. It involves two parties: the business and the factor. Factors are investors who pay cash for the right to receive the future payments on a business’ invoices. The business sells their invoices to the factor at a discount for immediate cash, while the factor waits for the rest of the money to be paid. Instead of waiting anywhere from 30 to 90 days for payment on a delivered service or purchase, a business can factor its receivables for cash at just a discount off the amount of the invoice. Dale Edwin Miller provides a great example of factoring on ezinearticles.com:
For example, Suppose ABC Company is selling widgets to XYZ Company, but XYZ Company takes 45 days to pay. ABC Company can not wait that long, and sell its invoice to LMN Factoring Company. Suppose ABC sells XYZ $100 worth of widgets. ABC then sells its invoice to LMN Factors. LMN factors wire to ABC Companies accounts $90 (creating a 90% advance rate). After 45 days XYZ Company pays LMN factors the amount of the invoice or $100. LMN Factors then wires $8 (more) to ABC Company and keeps $2, the discount rate.
In order to be eligible for factoring, businesses must be able to provide a client profile, information regarding receivable client accounts, and articles of incorporation to the factor. Next, the factor ensures that the business is a growing concern and the owners are legitimate, which then the factor begins to analyze their clients. If everything checks out, the factor will make arrangements to purchase the accounts from businesses if the invoices are submitted by their clients. Once the advance and discount rate are agreed upon, let the factoring begin!
Bank Loans vs. Factoring
During a cash flow crisis, many small business owners will immediately turn to the bank for a loan. Unfortunately, that may not always be the best route to take. Especially in this economy, a small business loan is very difficult, if not impossible, to obtain. Receiving a business loan indicates a debt to your business and is constantly costing interest. On the contrary, factoring creates zero obligation and puts money back into the bank. The only discrepancy is the loan interest rate, which frequently ends up being less than the factoring discount. Small businesses, especially those that are young and constantly growing, may want to see if factoring is a better option for their business rather than applying for a business loan. Before receiving a business loan, the bank looks at the financial records of the borrower to decide if they are stable enough to handle a loan. Factoring, on the other hand, looks at the client’s customers instead of the client themselves. A small business who is having some trouble paying the bills but a solid client base should look to factoring as they do not have established track records yet. The biggest requirement to gain approval for factoring is that you do business with creditworthy clients.
Is Factoring For My Business?
Factoring can offer many benefits to businesses, especially small businesses. First, factoring shortens the business cycle. It provides a continuing source of operating capital which allows businesses fast relief in a cash crunch situation. Because factoring is not a traditional loan, business owners also will not incur any further debt.On the other hand, traditional loans are typically 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 nature of your business. Another thing to consider is the 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, when done properly, is a great tool that allows small businesses to capitlize on their most precious asset—their invoices. —Cheryl Sowa
