Factoring in Cash Flow

In this economy, where credit is tight and requirements to obtain it are even tighter, there is an option available to provide a much-needed cash infusion and to reduce the risk of unpaid invoices: factoring. Factoring is a financial tool that can provide immediate cash flow to any size business.

Susan Palmer, a certified public accountant in Paoli, Pa., has witnessed many of her clients using this financial tool. “The cost benefit is there. People use it for cash flow,” she explains. “In this economic era, it’s essential.”

A factoring company takes responsibility for accounts receivable, paying from 75% to 90% of total invoices up front. When they collect from your customer, they pay you the balance of the invoices, less their fee.

Not a Loan, Not Invoice Discounting

Factoring depends on the value of account receivables, not the credit rating of your company. A typical loan includes you and the lending institution, whereas factoring involves the customer, the factor, and your company. Rather than providing a loan, the factor purchases a financial asset. There is less documentation and no collateral required, and there are no interest payments.

Sometimes, factoring is mistakenly called “invoice discounting.” This term refers to using receivables as collateral for a loan; they are not purchased.

What Will This Cost?

To determine cost, the factoring firm evaluates your receivables based on industry averages and specific account risks. The fee is a percentage of gross accounts, rates being higher for greater account risks. Other conditions used in determining terms involve monthly sales volume and individual invoice totals. Firms also consider time commitments to receivable sales. The factoring group may have a service charge in addition to interest fees, based on how long they must wait to collect payment.

Factoring groups offer varying arrangements. Non-recourse factoring is full purchase of accounts receivable, including the risk of nonpayment. Recourse factoring, on the other hand, means your company will be responsible for reimbursing the factoring company if the customer does not pay.

The Plus Side

There are several advantages to factoring. Factored cash is fast cash. It ensures consistent cash flow, especially important to businesses with cyclical sales. This facilitates financial planning by improving accuracy.

It’s also a viable financial tool for new businesses, since banks have stringent requirements for income history. Factoring is based on invoices from income already generated. For more established businesses, this method can increase capital available for growth without incurring debt.

Factoring accounts receivables removes bad debt from income statements; you can structure the arrangement so a third party assumes the risks of bad debt. Thus, business equity remains stable.

Another advantage is that you receive funds as soon as you invoice, as if the customer is paying cash at a discounted rate. In turn, your company can receive early-payment and volume discounts with your suppliers. You can offer credit terms as incentives to customers without impacting cash flow. Plus, it keeps debts current, saving money on interest and past-due fees. You also save time and labor costs that would be spent in collecting outstanding invoices, which can give you a substantial savings on overhead costs.

The Minus Side

There are also, however, some disadvantages to factoring. Since you receive a lower amount than the total revenue owed, factoring is more expensive than borrowing money, although it could be cost-effective in the long term. Since costs can run high, limit the amount factored to the minimum necessary for healthy cash flow.

There is the potential for customers to be upset about third-party collection attempts. Be clear when interviewing factoring firms about your expectations for customer communication, and understand the steps that the company will take to collect amounts owed. Reputable firms are professional about contact and can often encourage customers to pay faster than they might if they were paying you directly.

Additionally, customers may not want another company investigating their financial conditions and contacting them about amounts due. A factoring firm could require that the customer pay them directly, which could damage your customer relations. If you feel that your customers might react negatively to this requirement, consider negotiating against this practice.

Accounts receivables will not be available as collateral if you would also like to pursue a business loan, although having a history of consistent cash flow will help secure a loan in the long run.

How to Find a Factor

Palmer says that factoring has traditionally been used in manufacturing and wholesaling. “It hasn’t been used as much in services industries. People relate it to the manufacturing or wholesale process, when you have an inventory to maintain,” she explained.

Check with your commercial bank to determine if they have a division offering factoring services. Ask your Chamber of Commerce and other businesses in your area for recommendations.

Factors can vary in size, some operating locally and others dealing regionally or nationally. There are also companies that offer online quotes. Stick with firms that have good records and be certain to compare the terms of several different companies.

As you consider your options for increasing cash flow, contact the Small Business Administration, which offers workshops on factoring and other cash-flow solutions.

Factoring can free up your management and marketing team to expand your business and increase sales. In today’s volatile economic climate, factoring may increase your ability to profit from opportunities that might be missed due to lack of available cash. Check with your financial advisor to determine whether or not factoring makes sense for your business.

With regard to factoring, Palmer remarks, “I’m pro anything that keeps my clients floating.”

Story by Catia Whitmore