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Factoring Receivables: When it Makes Sense, When Not

Anita Campbell of Small Business TrendsAnita Campbell of Small Business Trends | February 14th, 2008 - 06:06 PM
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Factoring receivables is one of the forms of financing that sometimes gets the Rodney Dangerfield treatment – you know, “don’t get no respect.”

Factoring accounts receivables, also known as invoice factoring, is an established way of providing working funds for a business. But in my experience it’s also little known, and even flat-out misunderstood.

What Factoring Is

In its simplest form, factoring is when you sell your invoices (or accounts receivables) to a financing company called a factor. The factor advances a large chunk of the invoice amount, say 80%, immediately. The factor takes responsibility for collecting the invoice. When it is collected, they pay you the rest, less a factoring fee. Factoring fees may range from 2% to 15% of the invoice amount.

There’s usually less paperwork than in a bank loan. Turn-around times are much faster, too. Factors sometimes pay the initial sum within 48 hours.

For the right kind of business, factoring can be an excellent way to increase cash flow – the lifeline of any small business. It can even allow you to offload some of the headaches of collecting your receivables. Many factoring companies will handle  collections.

Difference between factoring and a loan

With a bank loan or credit cards, the bank or financial institution will make a decision based on your creditworthiness and your debt ratio (meaning your company’s and in many cases of small businesses, yours personally).

But in factoring, yours and your company’s creditworthiness are not the main issue. Rather, what the factoring company looks at is the party that owes you the receivable. It’s really your customer’s likelihood of paying that matters most to the factor.

Let’s say hypothetically that you are not able to qualify for a bank loan. Factoring could still be a viable option in that situation because your credit situation is not the main issue to the factor.

Wikipedia has a good discussion of the key differences between a bank loan and factoring receivables:

But is Factoring Right for Every Business?

The answer is a big “NO.”

Look, there are so many different forms of financing available to small businesses today, that no single type of financing is right for every business.

In fact, many if not most small businesses “layer” different types of financing. Think about it. You probably use some combination of credit cards, traditional loans, equipment leasing, working line of credit, factoring and/or whatever other financing forms give your business the necessary cash flow to operate and the most leverage to expand.

When is factoring right for your business?
A recent Kansas City Star article pointed out several advantages to accounts receivable factoring (sorry, link no longer available). The article pointed out that factoring can be helpful for businesses in the following five situations. My explanations and caveats are in parentheses next to each point:

• Business-to-business companies — (You must have sizeable invoices to assign to make it worthwhile for a factor to get involved, and that means invoices owed to you from other businesses. B-to-C companies will not have sizeable invoices.)

• Startups with strong accounts receivable — (Startups is a bit of a misnomer – remember, we’re not talking a 6-month old company here. Most raw startups simply don’t have enough receivables at first to assign to a factor. Think “young company” instead.)

• Accounts that take 30 or more days to pay — (The essence of factoring is that it speeds up the time in which you receive payment. If an account already pays you within 15 days, why would you want to assign that to a factoring company and have to pay factoring fees?)

• A special job or project where payment will be delayed – (A big project or possibly a government contract, where you do not get paid for months, could be crushing to your cash flow. If you anticipate these situations in advance you might try to up your pricing, just so you have enough cushion to later take advantage of factoring. In a way, it’s not that much different than giving a discount for early payment.)

• Cash-strapped businesses needing to meet a payroll or take advantage of a supplier’s cash discounts – (Hands down, factoring is one of the fastest sources of financing. Some factoring companies promise 24- to 48-hour turn around.)

Why Factoring Doesn’t Get No Respect

I think that factoring has developed a bad rap as being a financing source of “desperation.” In some cases that undoubtedly is true, especially because factoring is such a fast source of cash. But “desperate” businesses are hardly the only ones to use factoring.

Some businesses use factoring as a long-term strategy to manage cash flow, saving the traditional forms of credit for growth expansion and other needs. They bake in the costs of factoring fees into their pricing in advance, so that the fees don’t gobble profit margins.

Don’t let the bad rap stop you from investigating factoring to see if it is right for your business. But I would suggest that if you are going to use factoring, let it be because you’ve made a strategic decision after running the numbers, and decided that it’s your best source of cash flow. Don’t turn to factoring out of desperation.

Oh, and how to find a factoring company? Just search in Google – there are gazillions of them.

* * * * *
Anita Campbell is a writer, speaker and radio talk show host who closely follows trends in the small business market at her site, Small Business Trends.

Posted in Money Management

Posted:
6:06 PM on Feb 14, 2008
By: Anita Campbell

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9 Responses to “Factoring Receivables: When it Makes Sense, When Not”

  1. JakeBarkings | February 20th, 2008 at 1:17 pm

    Corporate finance is an area of finance dealing with the financial decisions corporations make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize corporate value while reducing the firm’s financial risks. Although it is in principle different from managerial finance which studies the financial decisions of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.

    The discipline can be divided into long-term and short-term decisions and techniques. Capital investment decisions are long-term choices about which projects receive investment, whether to finance that investment with equity or debt, and when or whether to pay dividends to shareholders. On the other hand, the short term decisions can be grouped under the heading “Working capital management”. This subject deals with the short-term balance of current assets and current liabilities; the focus here is on managing cash, inventories, and short-term borrowing and lending (such as the terms on credit extended to customers).

    The terms Corporate finance and Corporate financier are also associated with investment banking. The typical role of an investment banker is to evaluate investment projects for a bank to make investment decisions.

  2. Selling Your Invoices To Avoid That Small Business Squeeze » Small Business Trends | small business experts | February 21st, 2008 at 3:09 am

    […] understand why it doesn’t “get no respect,” read: “Factoring Receivables: When it Makes Sense, When Not.” Bookmark […]

  3. Amanda | February 21st, 2008 at 4:34 pm

    I can definitely see how factoring can relieve funds and tension. It seems that it could also free up some extra time to concentrate your efforts on other aspects of your business. Acoounts receivables can be a real headache.

  4. Anita Campbell of Small Business Trends | February 29th, 2008 at 12:46 am

    Amanda, yes, you said it! What a headache AR can be.

    One of the new forms of online services that I applaud are the new invoicing services. Blinksale and FreshBooks are examples. They take some of the drudgery out of invoicing and collecting, and help you do a better job of scheduling, processing and tracking payment.

    Take, for instance, a very small business or startup that is not a good candidate for factoring. Such a business could still improve A/R collection periods by (1) setting payment terms wisely — using, say, 2/10/net 30 terms — and (2) automating the billing process as much as possible using one of these new billing services.

    Sorry for getting so technical in this comment. But these kinds of discussions are what small businesses need if we really are to get at the nitty gritty it takes to strengthen our businesses.

    Anita

  5. raymond aboulafia | February 29th, 2008 at 12:52 pm

    Anita,
    Excellent article on factoring ,we truly enjoyed reading it.I would to point out that there are other types of Small Business loans that are more innovative,efficient and certainly more cost effective.I am referring to Business Cash Advance and Credit card loans.In the last 3 years these Small Business Funding techniques have become very
    popular with many Small and Medium size business
    owners.

  6. Anita Campbell of Small Business Trends | February 29th, 2008 at 1:45 pm

    Hi Raymond,

    Yes, this whole area of “accelerating cash flow” has exploded in the past few years, hasn’t it? There’s even an industry association for the many new funding alternatives available now.

    I’m not as familiar with business cash advances and credit card loans, as with traditional invoice factoring.

    I don’t want anyone to take this as an endorsement of credit card receipt acceleration (since I do not know enough about it to endorse the practice). But for educational purposes let me share what little I do know:

    If you have a retail business (often B2C) or a service business where most sales are made through credit cards, you essentially can sell your future credit card receipts. You sell your rights to receive future credit card payments in exchange for cash now.

    Advances on credit card receipts would be an alternative to traditional invoice factoring for businesses whose business model does not involve large invoices but get paid mostly via credit card.

    But — with any cash flow acceleration vehicle, make sure you run the numbers and understand all fees involved. As a business owner you’re already paying fees on credit card receipts, and to accelerate receipt of cash you will be adding another set of fees on top. You may need to adjust the prices you charge the customer to cover all the fees and still protect your profit. Understand those profit margins!

    Anybody out there have experience with cash advances on business credit card receipts that you wish to share? Share the good, the bad or the ugly … we want to hear it all.

    Anita

  7. Factoring Blog » Blog Archive | March 3rd, 2008 at 2:40 am

    […] There is an introduction to factoring over at the OPEN Forum blog. Check it out: Factoring Receivables: When it Makes Sense, When Not. […]

  8. Chris | March 10th, 2008 at 4:08 pm

    This is all news to me. I had never even heard of this before reading it - so thanks for posting it. I learn something new everyday.

  9. Anita Campbell of Small Business Trends | March 10th, 2008 at 4:22 pm

    Thanks, Chris! I so enjoy your comments and your loyal readership. Glad to see you drop by.

    Anita

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