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Factoring Receivables: When it Makes Sense, When Not
Feb 14, 2008 -
Factoring receivables is one of the forms of financing that sometimes gets the Rodney Dangerfield treatment – you know, "don't get no respect."Factoring accounts receivables, also known as invoice factoring, is an established way of providing working funds for a business. But in my experience it’s also little known, and even flat-out misunderstood.
What Factoring Is
In its simplest form, factoring is when you sell your invoices (or accounts receivables) to a financing company called a factor. The factor advances a large chunk of the invoice amount, say 80%, immediately. The factor takes responsibility for collecting the invoice. When it is collected, they pay you the rest, less a factoring fee. Factoring fees may range from 2% to 15% of the invoice amount.
There’s usually less paperwork than in a bank loan. Turn-around times are much faster, too. Factors sometimes pay the initial sum within 48 hours.
For the right kind of business, factoring can be an excellent way to increase cash flow – the lifeline of any small business. It can even allow you to offload some of the headaches of collecting your receivables. Many factoring companies will handle collections.
Difference between factoring and a loan
With a bank loan or credit cards, the bank or financial institution will make a decision based on your creditworthiness and your debt ratio (meaning your company’s and in many cases of small businesses, yours personally).
But in factoring, yours and your company’s creditworthiness are not the main issue. Rather, what the factoring company looks at is the party that owes you the receivable. It’s really your customer’s likelihood of paying that matters most to the factor.
Let’s say hypothetically that you are not able to qualify for a bank loan. Factoring could still be a viable option in that situation because your credit situation is not the main issue to the factor.
Wikipedia has a good discussion of the key differences between a bank loan and factoring receivables:
But is Factoring Right for Every Business?
The answer is a big “NO.”
Look, there are so many different forms of financing available to small businesses today, that no single type of financing is right for every business.
In fact, many if not most small businesses “layer” different types of financing. Think about it. You probably use some combination of credit cards, traditional loans, equipment leasing, working line of credit, factoring and/or whatever other financing forms give your business the necessary cash flow to operate and the most leverage to expand.
When is factoring right for your business?
A recent Kansas City Star article pointed out several advantages to accounts receivable factoring (sorry, link no longer available). The article pointed out that factoring can be helpful for businesses in the following five situations. My explanations and caveats are in parentheses next to each point:
• Business-to-business companies — (You must have sizeable invoices to assign to make it worthwhile for a factor to get involved, and that means invoices owed to you from other businesses. B-to-C companies will not have sizeable invoices.)
• Startups with strong accounts receivable — (Startups is a bit of a misnomer – remember, we’re not talking a 6-month old company here. Most raw startups simply don’t have enough receivables at first to assign to a factor. Think “young company” instead.)
• Accounts that take 30 or more days to pay — (The essence of factoring is that it speeds up the time in which you receive payment. If an account already pays you within 15 days, why would you want to assign that to a factoring company and have to pay factoring fees?)
• A special job or project where payment will be delayed – (A big project or possibly a government contract, where you do not get paid for months, could be crushing to your cash flow. If you anticipate these situations in advance you might try to up your pricing, just so you have enough cushion to later take advantage of factoring. In a way, it’s not that much different than giving a discount for early payment.)
• Cash-strapped businesses needing to meet a payroll or take advantage of a supplier’s cash discounts– (Hands down, factoring is one of the fastest sources of financing. Some factoring companies promise 24- to 48-hour turn around.)
Why Factoring Doesn’t Get No Respect
I think that factoring has developed a bad rap as being a financing source of “desperation.” In some cases that undoubtedly is true, especially because factoring is such a fast source of cash. But “desperate” businesses are hardly the only ones to use factoring.
Some businesses use factoring as a long-term strategy to manage cash flow, saving the traditional forms of credit for growth expansion and other needs. They bake in the costs of factoring fees into their pricing in advance, so that the fees don’t gobble profit margins.
Don’t let the bad rap stop you from investigating factoring to see if it is right for your business. But I would suggest that if you are going to use factoring, let it be because you’ve made a strategic decision after running the numbers, and decided that it’s your best source of cash flow. Don’t turn to factoring out of desperation.
Oh, and how to find a factoring company? Just search in Google – there are gazillions of them.
* * * * *
Anita Campbell is a writer, speaker and radio talk show host who closely follows trends in the small business market at her site, Small Business Trends.
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