In the first three posts of this series, I covered what you need to know about small business financing, how to align your funding sources with your funding needs and alternative sources for working capital. One of the important alternatives by which you can increase your working capital is through accounts receivable factoring. In this post, I will focus on some myths and realities surrounding invoice factoring.
What Is Factoring?
Accounts receivable (A/R) factoring, also known as "accounts receivable discounting" involves "selling" the A/R to a third party known as a "factor." Factoring is customer and invoice specific. The factor may or may not be willing to fund ("buy") all of your A/R invoices. There is a cost to factoring, which is typically 2 to 4 percent of the invoice's face value. The purpose of factoring is to accelerate cash receipts due from sales made on credit.
Full-service factoring involves selling all outstanding receivables on an ongoing basis to a commercial finance company (factor). The factor pays for each invoice, withholding 2 to 4 percent as its fee, and manages the receivable until it's paid. Under spot factoring, you would sell a specific invoice to the factor without any commitment to selling any additional invoices. Spot factoring is more expensive than full-service factoring, typically 5 to 8 percent of the receivable. Receivables may be sold with or without recourse. With recourse, if the customer defaults, you would have to attempt collection yourself. Without recourse, the factor would assume full collection responsibility. Factoring without recourse is more expensive because it carries a greater risk.
Myths and Realities
Even though factoring has literally been a source of small business financing for centuries, it's still a frequently misunderstood option. Unfortunately, these misunderstandings, or myths, may prevent companies from utilizing what could be a very valuable resource for them. Here are some of the most common invoice factoring myths:
- Factoring Is Bad for Your Reputation
The concern is that your customers may see your use of factoring as a sign that you're in financial trouble. While factoring is a viable tool for startup companies, or those who are otherwise un-creditworthy, it's also a very important tool for successful companies that want to rapidly accelerate their growth and need access to the working capital tied up in the receivables.
- Factoring Is Too Expensive
While factoring is certainly more expensive than a traditional bank loan, it may be the only viable option for a business that doesn't qualify for a bank loan to secure the funding needed to support their growth. Additionally, under full-service factoring, the factor may provide valuable additional services such as credit checks on potential customers, invoice account flow tracking and engagement in collections or related services as needed. A second important consideration is the time value of money. Can you earn more by having immediate access to the funds than the cost represented by selling the receivables? If factoring frees up the working capital necessary to support your growth, for example, and the profitability of the additional business available is greater than the cost of the factoring, then it represents a smart choice from a ROI perspective.
- Factoring Is Only for Small Companies/Factoring Is Only for Large Companies
Factoring has nothing to do with the size of the company that desires to accelerate payment on their A/Rs. Certainly for small companies, especially startups without a credit track record, factoring may be the primary tool available to them to build working capital. Further, support from a full-service factor may actually represent an effective way to outsource the A/R management function. Many larger, established and profitable companies use factoring as a routine component of their cash flow management strategy.
- Factoring May Upset Your Customers
Some customers may prefer dealing directly with you rather than with a third-party factor. This may be for the good reason that they appreciate the collaboration between companies. It may also be for the not-so-great reason that they feel it may be easier to delay payments if they're dealing directly with you rather than with a commercial finance company that may be more assertive in collection activities and in reporting delinquent accounts to credit monitoring agencies.
- Factors Have Inflexible Rules and Are Difficult to Deal With
Factors come in all types and sizes, and represent a wide range of business. For this reason, it's important to investigate different factoring agencies to find an organization that suits your purposes at a price that you feel is a fair value for the services provided.
As with all aspects of business management, factoring represents a tool that may be right for you. Don't be misled by invoice factoring myths. Understand your goals, investigate your alternatives and look for a strong business relationship.
In my next article in this series, I'll take a look at public sector funding resources: what you need to know and how to proceed.
Read the rest of the series.
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