Many small businesses struggle to finance new projects while they wait for their clients to pay previous invoices. Factoring receivables is one of the most popular ways to finance companies struggling with limited cash flow. This involves a larger company buying a business’s unpaid invoices for cash advances and helping it receive any outstanding payments it’s owed, for which the other company charges a fee. Here’s how to know whether factoring receivables is right for your business.
How factoring works
After you deliver a product or service to your client, you send them an invoice. The factoring company pays you immediately, using the invoice as collateral. Once the client pays the invoice, usually after 30 to 90 days, the transaction is closed.
Factoring can help your company grow rapidly and serve more clients. However, like any financing option, this method has its limitations and disadvantages.
[Read more: What Is Accounts Receivable?]
Cost of factoring receivables
Factoring receivable rates vary, but ultimately, the longer your customer takes to pay the invoice, the more you’ll owe the factoring company.
For instance, a factoring company could charge you 1% of the value of the invoice per month. If your invoice is $10,000, and your customer pays after the first month, you would only owe the factoring company $100. If your customer takes 3 months to pay, you would have to pay the company $300.
There are also two kinds of factoring: recourse and nonrecourse. With recourse factoring, you will have to cover any money your client refuses to pay. With nonrecourse factoring (a more expensive option), the factoring company will accept those potential losses.
Receivable factoring vs. receivable financing
Receivable financing is a loan that uses unpaid invoices as collateral. Small business owners receive funds based on the values of their unpaid invoices, and after they’re paid, those owners then pay the lenders back, plus any fees.
Receivable factoring is more expensive than receivable financing, as the factoring company takes responsibility for collecting unpaid invoices and, in the case of nonrecourse factoring, will accept the losses for any invoices that remain unpaid.
Pros of factoring receivables
There are many good reasons to consider factoring as a way to improve your company's cash flow.
Your business gets immediate cash to provide payment terms
The number one reason to factor invoices is to quickly provide your company with cash to fund a new project for a client. Most payment terms require the client to pay in 30, 60, or 90 days, which can limit the number of clients you take on while you wait for invoices. With factoring, you have the cash in hand almost immediately to provide payment terms to clients and start on new projects.
Nearly any business can factor invoices
Factoring receivables is usually much simpler than applying for a business loan. The requirements are fairly straightforward and allow you to work with new clients quickly. You can consider factoring if 1) you operate a business that has commercial or government clients with good credit, and 2) your business is free of liens, other encumbrances, and legal problems.
You can increase the line as needed
Factoring invoices is an excellent option for companies that are pursuing an aggressive growth stage, as it can scale with your business. As long as your clients have good credit, you can increase the number of factors your business maintains.
It can be a long- or short-term solution
Most factoring companies will work with you to create a plan as brief as six months to help fund your business. If your business enters a period of rapid, unexpected growth or runs into some financial trouble, factoring invoices can strengthen your cash flow. Alternatively, you can work with a factoring company for several years to grow gradually yet consistently.
Your invoices are your collateral
Most traditional financing options require significant assets, such as real estate or business equipment, to use as collateral. Factoring only uses invoices as collateral, so you don’t have to surrender business-critical assets if your business starts to struggle.
Factoring provides you with cash fast, but it usually costs more than traditional financial solutions offered by lenders.
Any size business can use factoring
Most lenders will hesitate to offer a line of credit to businesses without a long credit history or aggressive profit margins. Factoring can be used by even the smallest of businesses to expand operations.
You’ll have lower credit risk
When your small business exchanges unpaid invoices for money, all credit risk is allocated to the factoring company, as they assume the risk of your customers not paying what they owe you. Any payment difficulties are also the responsibility of the factoring company, not the small business.
You have improved control over your business
Any money you receive in exchange for your business’s unpaid invoices will help your company become more flexible. If your progress on projects like physical expansion or investment expansion have slowed due to a lack of payments, the added funds will help you move forward without that financial burden.
[Read more: Accounts Payable vs. Accounts Receivable]
Cons of factoring receivables
It doesn’t solve all of your financial issues
Traditional loans and lines of credit can be used for any number of reasons, such as paying suppliers, purchasing a storefront, and stocking inventory, to help your business remain successful. Factoring, on the other hand, only solves the problem of limited cash flow due to slow-paying clients.
It costs more than traditional lines of credit
Factoring provides you with cash fast, but it usually costs more than traditional financial solutions offered by lenders. With factoring, the rate and the advantage are used in conjunction to determine your actual rate, which usually results in a 1–4% rate per 30 days. This can decrease your business’s financial flexibility. However, receiving capital upfront can help offset these service fees, making the transaction a worthy investment.
Finance companies may contact your customers
When you start a business relationship with a factoring company, they will contact your clients to inform them that they are managing your invoices. Additionally, the factoring company may also contact your clients if your payments are late, which can have a significant negative impact on your business reputation. Additionally, your company assumes any and all bad debt incurred while working with a factoring company.
Payment risk
Often, as mentioned previously, the finance company will take on the responsibility of customer credit dues. However, if enough customers don’t pay their invoices, your small business can be held accountable for the factoring company’s lost fees. This is not true in the case of a nonrecourse exchange, as the financing company assumes the nonpayment risk.
Client risk
While factoring receivables can lead to lasting mutually beneficial relationships between businesses and financial institutions if your customers or clients are known for not fulfilling their invoices, odds are that the financial institution will not continue working with you. Finding another trustworthy factoring company can also be difficult.
When deciding whether to use factor receivables, consider your clients’ creditworthiness and any associated fees. If you can ensure the financing company does not lose money in the exchange, your business and theirs will benefit from factoring your receivables and will lead to reliable transactions in the future.
Factoring invoices can help you solve cash flow problems quickly, but the cost, time, and energy may not be the best solution for your business. If you do decide to partner with a factoring company, look for one that has a positive reputation in your specific industry and has been in business for many years.
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