Invoice on monitor
Factoring receivables is one way to improve company cash flow. — Getty Images/AndreyPopov

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 that are struggling with limited cash flow. Factoring uses an intermediary, a factoring company, to buy your invoices and advance you money against them.

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 between 30 and 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. Here are some pros and cons of factoring receivables to consider.

Pros of factoring receivables

There are many good reasons to consider factoring as a way to improve your company's cash flow.

1. 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.

2. 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, or other encumbrances, and legal problems. If you meet these criteria, you can consider factoring.

3. 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.

Factoring invoices is an excellent option for companies that are pursuing an aggressive growth stage.

4. It can be a long- or short-term solution. Most factoring companies will work with you to create a plan as low 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.

5. Your invoices are your collateral. Most traditional financing options require significant assets to use as collateral, such as real estate or business equipment. Factoring only uses invoices as collateral, so you don’t have to surrender business-critical assets if your business starts to struggle.

6. 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 your operation.

Cons of factoring receivables

1. It doesn’t solve all of your financial issues. Traditional loans and lines of credit can be used for any number of reasons to help your business remain successful, such as paying suppliers, purchasing a storefront, and stocking inventory. Factoring, on the other hand, only solves the problem of limited cash flow due to slow-paying clients.

2. 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.

3. 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.

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.

CO— does not review or recommend products or services. For more information on choosing the best business loan and financing options, visit our friends at business.com.

CO— aims to bring you inspiration from leading respected experts. However, before making any business decision, you should consult a professional who can advise you based on your individual situation.

Published February 25, 2019