Cash flow is the lifeblood of any business but can be especially crucial to small and growing businesses. The natural lag between purchasing supplies and collecting sales receipts from customers can place limits on growth and possibly threaten the viability of your company. To shorten the time between cash investment and collecting a return on investment, many businesses use the services of a factoring company.
A factoring company buys receivables at a discount in exchange for providing cash upfront, representing some portion of the value of those receivables. This practice can be a useful cash-flow management tool under any circumstances but can be especially valuable during economic slowdowns. During slowdowns, cash flow issues can become acute, as customers delay payments and banks tighten lending standards. A factoring company can solve this problem by keeping cash flowing.
How Factoring Services Work
It helps to start by remembering that in accounting terms, receivables are an asset. Normally the big drawback of these assets is that they are illiquid until payment is collected. A factoring company, however, can provide some liquidity for these assets upfront.
Your receivables and the factoring company start by agreeing on two things: the amount of cash to be provided upfront against the book of receivables, and the fee to be earned by the factoring company in return for buying them.
Fees for factoring services are typically between 1 percent and 5 percent. The shakier your credit, the higher the fee is likely to be. Suppose the factoring company and you agree to a 3 percent fee on $10,000 worth of receivables. Effectively this means the factoring company has agreed to purchase those receivables for $9,700. The factoring company then provides the bulk of this to you upfront, holding back a portion as a reserve against collection problems. The factoring company will then handle collections and, assuming the receivables are eventually paid in full, forward the remainder of the reserve to you.
Benefits of Using Factoring Services
There are several benefits to selling receivables at a discount:
- Cash flow is accelerated, meaning money is available sooner to pay off existing obligations and reinvest in the business.
- You can spend more time on the core business and less time managing receivables.
- New businesses without a credit history can obtain startup financing that wouldn’t be available from banks.
- Approval is expedited, with a much more streamlined process than for a loan.
- Approval is based on the credit quality of the merchant’s customers, not on the merchant’s credit history; so a business with credit problems but with a good customer base can get access to financing.
Choosing a Factoring Company
Here are some points to consider in the decision process:
- What fee will the factoring company charge? This fee is highly dependent on the characteristics of the receivables involved, so getting competitive quotes can be well worthwhile.
- What is the processing time, from application to payment? Since factoring is largely about solving a timing problem with cash flow, response times are very important.
- How well-funded is the factoring company? Ideally a successful factoring relationship should become a regular part of doing business, so the ability of the company to provide financing on a consistent basis matters greatly.
- What track record does the factoring company have with similar businesses? A proven fit means the factoring company should understand your business and customer base.
Factoring is applied to a wide range of businesses, including both products and services. It is applicable to so many situations because, whatever the nature of the business, cash flow is pretty much a universal challenge.