Some small businesses that need cash in a hurry turn to receivables financing as a quick, reliable source of capital.
Commonly known as factoring, receivables financing can be an effective way for a small business to boost cash flow without incurring additional debt. To use this financing method, a small business sells its accounts receivable to a third party called a factor. The factor advances to the business the value of the receivables -- less a fee -- and then acts as a collection agent for the company, assuming responsibility for collecting the money your business is owed.
Who uses factoring
Factoring is not for all kinds of businesses. First off, you generally have to have a significant volume of accounts receivable for a factor to be interested in working with you -- figure a minimum monthly volume of around $8,000-$10,000. As a result, this form of funding may be best for rapidly growing companies that are looking for a way to stall cash flow problems. It is also commonly used in some industries -- such as apparel manufacturing -- where the value of net-30 and net-60 receivables is needed to ramp up manufacturing and inventory. Finally, factoring should be considered a form of short-term financing; it is not a remedy to a longer-term cash need.
Your ability to utilize factoring as a financing method also depends significantly on the credit worthiness of your customers and the age of your receivables. Unlike other forms of financing where lenders will closely examine your credit history, factors will need to assess the financial stability of your customers. They want to mitigate any risk associated with collecting receivables to ensure they get paid with minimal consequence.
Advantages of factoring
Factoring receivables can help a cash-needy business in several ways:
- Speed: Selling receivables allows you to generate cash sooner than having to collect the funds on your own. From the time you contact a factor, you can have your money in a week or two. If you have an existing relationship with a factor, you may be able to turn financing around in a couple of days.
- Lack of debt: Factoring is not a loan but a sale of assets. Businesses that can't qualify for debt financing, or don't want to take on additional debt, may find this preferable to taking out a loan.
- Simplified collections: Because the factor handles debt collection, your company does not have to worry about collecting receivables.
Disadvantages of factoring
Factoring also has its downside:
- Cost: Factoring can be costly. In some cases, you will receive only a portion of the value of receivables up front, with the remainder coming when customers pay their bills to the factor. The factor's fee can also be anywhere from 5-10 percent of the value of the receivables. Traditional loans will typically cost less than factoring.
- Flexibility: You generally can't sell older or long-term receivables to a factor. For instance, many factors will not consider invoices with longer than 90-day payment terms. In addition, factors will determine your costs based on the credit history of your customers, so factoring is not an alternative for companies that are having trouble collecting payments.
Locating a factor
To find a factor for your business, you can consult The Edwards Directory of American Factors, a reference guide that provides profiles of factors by name and state. This guide is available at many business libraries, or can be ordered from the publisher at 800-963-1993.
You can also contact the International Factoring Association, a trade group that serves the factoring industry. It will put you in touch with member factors in your area that meet your specific criteria.