There is nothing more frustrating to a business owner then having to turn away sales because he or she lacks the cash flow to support them. For companies that sell products, this means not being able to replenish inventory in time to capitalize on new opportunities. For companies in the service industry, this means not being able to pay the additional employees (or hours) needed to cover additional service requests. This problem is fairly common, especially for small and mid-size businesses.
If you are not able to get approved for bank financing, there is an alternative solution that can work better than a small business loan — especially if your challenge is that you cannot wait 30 to 60 days to get paid by clients. It’s called “factoring.”
Factoring is a financing method in which a business owner sells accounts receivables at a discount to a third party (factor) for immediate cash. For example, you have an invoice for $1,000, which your customer is not going to pay for 30 days. This creates a cash-flow issue since you might need the money to meet payroll or buy inventory. You can submit the invoice to the factor and they will usually advance 75-85% of the invoice amount to you within 24-48 hours once they have verified your invoice. The factor will hold the remaining 15-25% in reserves. Once your customer pays the invoice, your fee is calculated and deducted from the reserves with the difference being refunded to you at that time.
With factoring, the emphasis is on your customers’ credit, not yours. Unlike with banks, you can qualify with poor credit, bankruptcies, short sales or foreclosures, being a startup company or a company showing losses.
Recourse factoring versus non-recourse factoring
Most factoring companies are recourse. In recourse factoring, an invoice is factored with the expectation that your customers will pay within 90 days. If they do not, then you have to pay back the factoring company. If you are with a non-recourse factoring company and the customer doesn’t pay the invoice due to its insolvency within the 90-day period, you will not have to pay back the factoring company. This doesn’t protect you if your customer doesn’t pay because it has a dispute or are simply low on funds — you will still be liable to the factoring company after 90 days.
Benefits of factoring your receivables
There are many benefits to companies that choose to factor their accounts receivables. In addition to the previously mentioned benefits – being able to meet payroll demands or to buy inventory — you can also capitalize on supplier discounts. Many suppliers offer discounts if they are paid in a short period of time. Another benefit is you can increase sales by offering better terms to your customers. You will be in a position to extend credit terms to larger customers without requiring them to pay COD or jeopardize losing the business. If you need to build or repair your credit rating and credit score, factoring will give you immediate cash so you can pay your bills on time, or even early, which will raise your credit score, giving you increased borrowing power when you need it — definitely a benefit of factoring. But the primary benefit is that it helps your business get working capital without taking on new debt or diluting ownership of your company by bringing in new investors. Invoice factoring is a solution to free up capital and have it available when you need it. Your business will be able to invest resources in areas where it can help you become more profitable.
Common myths about factoring
A common myth is that factoring is too expensive. A lot of business owners make the mistake of equating factoring fees with interest rates on loans. Business factoring fees are not equivalent to annualized interest rates. For example, if a factoring company charges 2% per 30 days an invoice is outstanding, it cannot be translated to a 24% APR. Rather, a factoring company’s fee stops the day the invoice is paid. You will not typically wait 12 months to receive payment on an invoice.
For factoring receivables, generally the factor fee ranges between 1 ½ -3 % on the amount of your invoice per 30 days outstanding. Let’s use our earlier example of submitting an invoice for $1,000, which your customer is not going to pay for 30 days. If your factor fee was 2%, it would cost you $20.
Some factoring companies might have other fees they charge along with the factor fee, mostly for things such as credit checks, processing, volume requirements or early termination. Ask them and read the contract. It may state “the factor can charge additional fees as needed.” You should know what these are.
Another myth is that by using factoring, it is a sign to your customers that your business is weak. No need to worry. Factoring is not a new form of financing. Many industries rely on the services a factor provides and most likely, your customer is already familiar with it or could be using a factoring company themselves.
Questions you should ask the factoring company
Besides the previously mentioned things you should know, you should ask a factor:
- How long does it take to get set up for factoring?
- Can I pick and choose invoices that I want to factor or do you require factoring of all invoices?
- What is the process of getting one of my customers approved for funding?
- Is there a minimum invoice amount?
- What is your notification and verification process?
- Do you offer daily, 5-, 10-, 15- or 30-day rates?
- Will you require a contract term or have volume requirements?
- Once my customer pays the invoice, how long before I receive my reserves?
- Can I go online to check status of outstanding invoices?
- Will I be required to sign a Personal or Validity Guarantee?
- What is your interaction with my customers regarding collections?
Hopefully this increases the understanding of recievable factoring and how it can improve cash flow and expand your business. Traditional lenders can’t always provide the solutions, so it makes sense to keep an open mind to alternative forms of financing. Working with a company that is experienced in the area of invoice factoring can be invaluable for those with these cash-flow needs.
Cheryl O’Neill Gowen is president and CEO of Alternative Funding Options. She works with business owners seeking cash flow from non-traditional sources, drawing on more than 30 years’ experience in banking, financing and staffing. Contact her at: firstname.lastname@example.org.
Article as it appears in the Business Observer.