Most businesses need to extend credit to attract customers, but they also need steady cash flow. Financial factoring allows you to extend credit, but have the cash you need to maintain your business momentum. In today’s strict lending environment, borrowing money from lending institutions can be difficult or impossible for startups.
How can you keep your business afloat if you can’t borrow the cash you need? SMBs can take advantage of financial factoring to give them the cash they need when they have extended credit to their customers and can’t wait for the credit due date.
What is Factoring?
If your business invoices clients, you can wait 30, 60 or up to 90 days to receive the money you need for your business activities. In the meantime, you may need cash for a variety of reasons. One way to get the cash you need is to sell your accounts receivable to a third party (the “factor”). Two types of financial factoring are available:
- Recourse factoring requires you to buy back receivables the factor is unable to collect
- In non-recourse factoring, the company that buys your receivables accepts the risk of non-repayment
Non-recourse factoring is more expensive than recourse financing because the factor (the buyer) is assuming the risk.
How Factoring Works
Factoring is a fairly straightforward process. After you have invoiced your client for a product or service, you take your invoice or invoices to a bank or other financial institution that offers factoring services. They review the invoices individually, checking the customers’ credit ratings to reduce their risk. When your application is approved, they will give you 80% to 90% of the value of the invoice.
The financial institution assumes responsibility for collecting the debt. After the debt is paid, they send you the balance minus their fees, which can range from 1% to 5% of the value of the accounts receivable. The rate you pay can be negotiable. A startup’s cash flow statements frequently show more cash going out than cash being received as the company waits for invoices to be paid. Financial factoring can be a good way to improve cash flow, but it’s not without some risks.
The Risks of Factoring Paying up to 5% of the value of your receivables can be an investment worth making, but if you consistently turn to factor to prop up your cash flow, the loss becomes significant. For example, if you have 30-day receivables and take advantage of factoring every month for a year, you’ll have to multiply your percentage rate by 12.
When a factoring company takes possession of your invoices, they also become debt collectors. In most cases, they will handle debt collection sensitively, but their primary objective is to collect the debt. In some cases, they may not be as sensitive to your clients’ circumstances as you would be and you could lose your clients’ trust. It’s best to use financial factoring only when necessary and strive to have positive cash flow without having to rely on outside financing.
Software like QuickBooks Online can help you manage your cash flow and organize your business’s finances easily and accurately. Despite the risks, factoring can be a good way to improve cash flow. To avoid any risks, however, consider exploring factoring before a negative cash flow forces you to negotiate from a position of weakness.