Any experienced business owner will tell you that money is a very crucial metric for measuring how well a business is doing.
The income statement of the business will show whether expenses are managed properly and whether the business is making enough revenue and profits to justify business continuity.
But for the over 30 million businesses in the U.S., having a negative cash flow can pull a company down despite it having a strong business model that’s generating immense profits. For this reason, efficient management of accounts receivable is crucial to the success of the business.
Accounts receivable are the biggest assets on a company’s balance sheet. If your business grants payment terms to your clients, this asset lies in a dormant state until the clients make their payments.
If this is the case with your business, you need to consider taking up receivable factoring.
Receivable factoring, or accounts receivable financing, is a decent way of accessing capital to keep your business running without you having to borrow a loan.
Below is a detailed guide on all the facts you need to know about receivable factoring.
Factoring Is Not New to This World
If you’re just coming across the concept of ‘receivable factoring’ for the first time, you might be surprised to know that factoring has been around since ancient Rome.
Rich merchants and producers during the Roman era used to hire an agent to manage the sale and delivery of their products. These agents acted as factors and were commonly used during the Middle Ages.
In the U.S, colonialists looked for people to advance payments on materials that were transported to England during the early 15th Century.
At the time, factoring services mainly involved taking physical possession of goods on consignment and storing them before finding an ideal buyer. Once the buyer was found, the factor would deliver the goods and collect payments on behalf of the buyer.
The factor would receive a commission in exchange for their services. As the number of these factors grew significantly, some became affluent enough to extend credit to exporters. The credit was guaranteed by the right of the factor to reimburse themselves from the value of the sold goods.
If you think 60 days is a long time to wait for invoiced clients to pay, think about how U.S. based cotton exporters had to wait for their product to get to Europe and eventually the buyer’s market. They then had to wait for their money to make the sea voyage back .
However, later advances in infrastructure made it unnecessary for exporters to use factors to sell their goods. They instead preferred salesmen who eliminated the need for storage and distribution services provided by factors.
Nevertheless, exporters still remained in need of financing services which gave birth to the modern factors as we know them today.
Receivable Factoring Transforms Accounts Receivable Into Capital
By selling outstanding accounts receivable to a factoring company, the business gets an immediate cash advance that frees up the cash flow they need to fund the growth of the company.
You don’t have to wait 30, 60, or 90 days for your client to make their payments. Receivable factoring helps businesses get an advance of similar value to the sold accounts receivable so they can fund operational expenses such as staff payroll.
It Is a Fairly Easy Process
Let’s say you’re a business with unpaid invoices totaling to $40,000 that you need paid within the following 5 days if you’re going to make the weekly payroll.
In this scenario, you would reach out to a factoring company and sell your invoices at a small discount. The factoring company will give you a certain percentage of the accounts receivable upfront, usually between 80% and 95%, depending on the factor.
From there, you’ll have the money you need to pay your employees and the factoring company is then the current holder of the invoices. This means they will take up the responsibility of making sure the accounts receivable are paid so they can make their money back.
Process Times Are Quick
If you’ve ever applied for a business loan, you should know that it takes anywhere between 2 to 3 months for your loan request to be processed. This waiting period can be excruciating especially if you are in urgent need of the money.
You’ll have to compile a series of documents detailing your personal and company background information, bank statements, tax returns, credit reports, and tax returns. This situation can get even worse if you find that after all that time and effort, you’re only eligible for a subsidized amount or have not qualified for the loan altogether.
With receivable factoring, the application process only requires a mere fraction of the paperwork required by a bank, and without collateral. Upon application approval, you can expect the advance to reflect in your account within 1 to 3 working business days.
This wait time can get even shorter if you factor with a particular company on a regular basis.
There Are Various Approaches to Accounts Receivable Factoring
There are two different ways used to classify receivable factoring. The first one depends on how receivable factoring is used as a financing tool:
- Spot Factoring: Involves infrequently accessing money from a factor during cash flow emergencies.
- Whole turnover: A business sells invoices to a factor who issues a cash advance at a discount. The factor pays the balance when they collect payment on the factored invoices.
- Selective: A business establishes a long-term relationship with a factor. The factor allows the business to choose which accounts receivable to factor and when.
The second approach to receivable factoring is based on the structure of the agreement between a business and the factor. They include:
Factoring with Recourse
The factor releases an advance payment to a business after buying its invoices. At this point, the factor is obligated to collect the payment on the bought invoices and forward balances to the business.
If the factor is unable to collect, the business pays back the advance they received from the factor.
Non-Recourse Factoring
Non-recourse receivable factoring works the same way as recourse factoring. But with non-recourse factoring, the factor is fully liable for uncollected accounts receivable. The business is absolved of any responsibility regarding the unpaid invoices.
Since this agreement means the factor takes on a higher risk, non-recourse factoring is a costlier option compared to when factoring with recourse.
Cash Advances From Receivable Factoring Is Not a Loan
While receivable factoring is recognized as a form of financing, it’s not really a loan. Factoring simply allows you to access money that you’ve already earned through a cash advance. It has no impact on your credit rating and it won’t appear on your company’s balance sheet as debt.
Since the cash advance is not a loan, it is much easier to obtain compared to a business loan from a bank. While you might be asked to submit a business strategy or some sort of collateral to get a bank loan, with receivable factoring, the only thing you’ll need is your accounts receivable.
For a factor to consider you eligible, they’ll have to analyze the credit worthiness of your clients. The fiscal history and performance of your company do not affect your chances of receiving the advance.
Receivable Factoring is Affordable
When industries started to really catch on to factoring as an alternative financing solution, the stereotype was that it was expensive and only beneficial to companies in extreme financial hardship.
But that was then. Factoring companies have since made their services relatively affordable for small and medium-sized businesses today.
Most factoring companies charge a rate between 0.5% to 5% of the invoiced amount. This rate is affected by the credit worthiness of a business’s clientele, its industry of operation, and the length of time in which the outstanding invoice is due.
Factors have also customized their services and features to meet the needs of business. Same day funding, low rates, and accounts receivable management, among other value added services have changed the factoring industry.
You’ll find that with fast payment, companies are able to improve business operations. This helps them save money and cut on costs by using the money to smoothen their operations and make them more efficient.
Is Receivable Factoring Right for Your Business
Cash crunches from unpaid accounts receivable can be frustrating for any business owner. Invoice factoring is a great alternative to business financing for companies who provide payment terms to their customers.
However, it’s not always the best solution for a small business. Before committing to a factoring contract, make sure you analyze the pros and cons of the agreement to your business.
Consider the needs of your enterprise when you go to the market in search of an ideal factoring company and ask the right questions. With all the facts highlighted above on factoring, you should have a good understanding of the factoring industry and how you can use it to elevate your business to new heights.