As a business owner, you want to be paid for your services.
It’s only fair.
You did hold up your end of the deal after all.
Getting customer to pay invoices quickly is a big component.
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The problem is that people are generally in no rush to part with their own cash.
You can use business credit cards.
You can also use business loans or lines of credit to help bridge the gap.
There is, however, another option that many people are not familiar with.
It’s called accounts receivable financing or simply “receivables factoring”.
Here’s a brief guide to help you understand the process and its benefits.
What is meant by “receivables factoring”
In the traditional sense, receivables factoring means the sale of your accounts receivables to a third party for a percentage of the outstanding balance.
That party assumes responsibility for the risk involved with collecting the balance from your customers.
Many factoring companies have started to offer “invoicing discounts” under the moniker of factoring. Invoice discounting is simply a short-term loan using the accounts receivable as collateral.
What are factoring companies?
The companies that perform the factoring service are called factoring companies.
Factoring companies are businesses that either purchase your accounts receivables outright or will advance you the invoice amounts to help free up cash to grow your business.
In the simplest terms, factoring companies act like partners that help accelerate your cash flow by improving collections as well as reducing your own exposure to bad debt.
They are also known as “factors” for short.
How do factoring companies work?
The factoring companies take on the responsibility of dealing with your clients in order to collect on your invoices.
Generally, the process works like this:
- You contact the factoring company
- The factoring company ensures your customers’ credit worthiness
- You send the agreed-upon invoices to the factoring company & they notify your customers
- The factoring company advances you a percentage of the invoices
- The customers pay the factoring company
- The factoring company remits the remaining balance to you (less fees)
What are the advantages of using receivables factoring?
There are five main advantages to using a factoring company:
- Streamlining administrative tasks – The factoring company handles all credit checks on your customers as well as managing collections. This enables you to reduce the expenses related to the tasks as well as minimizing bad debt.
- Improving financial health – Having the free cash flow enables you to pay suppliers, meet payroll obligations, and negotiate better supplier terms.
- Growing your business – With the cash available sooner, you don’t have to turn down business due to a lack of obtaining supplies and materials. You can keep taking on new customers and growing your business at a faster pace.
- Easier than working with banks – With banks, it’s difficult for new or small businesses to get lines of credit. With most factoring companies, you only have to have a minimum operating history, and the application process has a quick turnaround time (sometimes within 24 hours).
- Retain equity – If you look to outside investors for capital, you most likely have to give up a portion of your ownership interest (equity). When factoring receivables, you only give up the fee and interest while retaining complete control of your equity.
What are the disadvantages of receivables factoring?
Nothing is perfect, and contracting with a factoring company is no different. Just as there are benefits, there are also drawbacks:
- Cost – Not only do you have to pay a fee to the factoring company for their service, you also have to pay interest on the cash advance. The higher the risk, or the smaller the service amount, the higher the cost will be. Plus, the rates you pay will be significantly higher than traditional bank products.
- Loss of Customers – Most people don’t fully understand what receivables factoring is. Some might think it’s a debt-collection company (as in “you’re getting a black make on your credit report”) or take it as a sign your business is in financial distress. Some customers may simple prefer dealing with you directly and be turned off by a third party’s involvement. Any one of these attitudes can cause customers to go elsewhere.
- Time Commitments – Most factoring companies require a contract, and don’t work as a one-off engagement. That can be a stumbling block to business owners who aren’t interested in being locked into a deal such as this.
There is some misinformation on the web concerning control as a disadvantage.
This “source” incorrectly state that the factoring companies can deny your ability to work with poorly-rated customers.
When a factoring company declines one of your customers that does not mean you can’t work with that customer. All that means is you cannot factor that particular customer’s invoices.
The truth is you do not have to factor all of your invoices, and you can do business with any business directly regardless of the factoring company’s findings as to their credit-worthiness.
Who can benefit from receivables factoring?
Receivables factoring is usually offered to businesses working under business-to-business (B2B) and business-to-government (B2G) models.
The reason for this is that those working under the business-to-customer (B2C) model generally require immediate payment.
But, any business that offer payment terms of net-30 or longer can benefit from the advanced payments offered by factoring companies (although some factoring companies will not with the B2C sector).
Also, because the customers’ credit is in focus, it’s an ideal opportunity for newer businesses or those with poor credit (or principles with low credit scores) to improve cash flow.
Who is responsible for uncollected invoices?
There are two types of factoring:
- Recourse Factoring – This is the most common factoring arrangement. You are responsible for all uncollectable accounts, and will be required to purchase them back from the factoring companies. Since there is not risk to the factor, the costs to you are lower.
- Non-recourse Factoring – Under this arrangement, the factor is burdened with the risk of default. The client acceptance process is more stringent, and your costs are higher, due to the shift in risk. Some factors limit non-recourse arrangements to cases of bankruptcy, so you may actually be liable to buy back the accounts of client that simply close up or disappear.
Receivables factoring isn’t for everybody, and not all factoring companies are the same.
You have to do your due diligence to determine what method of funding will work best for you.
If you do decide to use receivables factoring, you will also have to shop around to find a factoring company that is reputable and will work best for what your needs are.
Businesses that are struggling with cash flow and can’t qualify for traditional bank-based funding options may find a factoring company to be not only a valuable business partner, but their last hope to avoid insolvency and, ultimately, bankruptcy.