From time to time, nearly every business experiences cash shortfalls due to the timing of cash payments vs. receipts.
Why do shortfalls happen? It all goes back to the cash conversion cycle. Most businesses pay workers on a weekly or biweekly basis. They also try to pay suppliers and vendors in accordance with the negotiated payment terms (typically net 30 days). Some might even pay creditors early to take advantage of early payment discounts. These payments, along with any loan payments, drain cash from the business’s bank accounts.
Meanwhile, it takes time for the business to invoice customers and then collect what’s outstanding. The end result is often a cash crunch, especially during seasonal peaks when cash outflows temporarily outpace cash inflows.
Factoring to the Rescue
While it’s not always possible to slow payments to creditors, business owners can generate much-needed cash by selling the rights to collect the firm’s accounts receivables to a third party. Selling accounts receivable balances, also known as factoring, generates immediate cash in exchange for fees paid to the factoring firm.
Here’s how it usually works:
- Your customer owes $6,700.
- You sell the right to collect the balance to a factoring firm (or factor) for 80% of the face value or $5,360 ($6,700 times 80%). The factoring company sends you that amount, known as the advance.
- The difference between the amount the customer owes and the advanced ($1,340) is known as a reserve.
- The factoring firm charges a fee of 1% for each month that the reserve remains outstanding.
- The customer pays the invoice after 30 days.
- The factoring firm retains 1% of the reserve ($13.40). The factor then sends you the remaining balance ($1,326.60), known as the rebate.
- In addition to a discount fee, factoring firms typically deduct additional fees from the rebate, including bank fees, cancellation fees, due diligence fees and a fee for the initial application.
Research Factoring Companies
Think factoring might work for your business? Here are some important questions to ask before you hand over your receivables to a third party.
Should you enter into a recourse or nonrecourse factoring arrangement? Signing a recourse factoring agreement means that your company agrees to buy back receivables that the factoring company doesn’t collect.
With a nonrecourse factoring arrangement, the risk of a customer defaulting generally transfers to the factoring company and, in most circumstances, doesn’t come back to your business. However, there may be exceptions where the factor would require your business to buy back the receivable.
Does the factor understand your industry? Factors that specialize in certain sectors, such as trucking, real estate or construction, are likely to have a strong grasp on industry terminology and understand the challenges of collecting from customers. Remember, factors hold back a reserve and charge a fee that increases the longer a balance remains uncollected. The quicker a customer pays, the lower the fees deducted and the greater rebate you receive.
How quickly will the factor advance funds? When cash is tight, timing is crucial. Before factoring your first receivable, establish how long it typically takes the factoring firm to issue an advance. In addition, gain a detailed understanding of the process your company must follow to submit an account. Most factoring firms provide small businesses with access to a dedicated online portal to submit new requests quickly.
What advance rate and fees does the factor require? Factoring companies generate income from two sources: the discount fee and miscellaneous charges related to creating the factoring relationship and maintaining and collecting on the factored accounts. Advances range from 70% to 98%, depending on the business and the solvency of its customers.
How financially stable is the factor? The success of a factor depends on its ability to provide advances and pay rebates in a timely manner. Ask each of the factoring firms you’re considering for an overview of their funding sources.
Ask each factoring firm you consider for a detailed breakdown of fees they charge. Create a simple spreadsheet for each firm’s fee structure. Be sure to ask if they require a monthly minimum transaction. Factoring less than the monthly minimum generates additional fees to maintain the financing relationship. Also search for online reviews and ratings for each firm. Pay close attention to reports regarding delays, excessive fees and an inability to collect on reserves. These all point to operational challenges and reasons to avoid that firm.
Pick a Winner
A number of factoring firms exist, so take the time to evaluate which one best suits your needs. And remember, while factoring your accounts receivables can provide access to cash, it’s just one of many ways your business can improve its cash flow. Consult with your financial advisors to devise the optimal cash flow strategy for your situation.