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How a Factoring Company Can Help Grow Your Business
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Startups and struggling small businesses often experience cash flow issues at some point in their lifetime. When cash flow is an issue, many companies resort to external business financing. However, financing is difficult to obtain from banks or other traditional lenders when cash flow is an issue. These businesses often turn to alternative financing solutions when a traditional lender is not an option. A possible alternative is working with a factoring company which is among the lesser-known financing solutions. Factoring companies work with other businesses that have cash flow problems and purchase their accounts receivables.
To learn more about invoice factoring, what it is, how much it costs, and factors to consider when working with a factoring company, continue reading below.
What is a Factoring Company?
A factoring company works with other companies that have cash flow problems, due to slow-paying customers and long payment terms, by purchasing invoices. It is important to note that factoring companies are not in the business of lending money. They purchase accounts receivables, or invoices, from their clients and earn a small profit.
How Does Invoice Factoring Work?
Invoice factoring is actually a simple process. A factoring company purchase accounts receivable in two installments. The first installment is extended to the client the moment the invoice sale is complete. The first installment will be 70% to 90% of the invoice amount, the exact percentage varies by industry and factoring company.
The second installment is extended when the accounts receivable is collected. The payment will be the remaining 10% to 30% that was not paid in the initial installment less the financing fee of the factoring company. The customer does not need to pay sooner, they can pay at their regular pace.
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What Happens If the Invoice Factoring Customer Doesn’t Pay?
Unfortunately, there will always be a case or two where the accounts receivable is never collected. This would mean that the client would be unable to repay the factoring company. How these circumstances are handled depends on the terms within your invoice factoring agreement. There are two types of methods: recourse and non-recourse accounts. Let’s explore both below.
If the terms of your agreement are non-recourse, the responsibility to collect delinquent accounts is with the factoring company. If the factoring company can’t collect, they take the loss and the client is not penalized. This is a favourable option for the client because money from the factoring company can be spent freely without having to worry about delinquent accounts.
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If the terms of your agreement are recourse, the responsibility to collect delinquent accounts could fall on the client. In some instances, this is the only type of agreement factoring companies offer. In other instances, the recourse account might pay a larger percentage of the invoice value due to the added security of the factor.
Under recourse accounts, the client can buy back the invoice from the factoring company and try to collect on their own. Under this option, there are several possible legal actions you can take to collect a significantly overdue debt. If you don’t have the funds available to repurchase an invoice, you can swap invoices with the factoring company. The new invoice will replace the amount of the delinquent invoice, then you can attempt to collect a debt.
Who Can Work with Factoring Companies
Virtually anyone can work with a factoring company where goods and services are sold on account with net 30 to net 60 payment terms. Some industries use factoring companies more than others, below is a list of industries that commonly use factoring.
- Medical supplies
- Office supply
- And many more
Advantages and Disadvantages of Working With Factoring Companies
As with any form of financing, there are various pros and cons to consider before making a final decision to proceed. Let’s explore the advantages and disadvantages below.
- Immediate Cash Flow Improvement. Once an invoice is sold to a factoring company, cash is received immediately. Your cash flow will improve which can help you pay expenses necessary to operate.
- Grow Your Business. By having cash readily available, you can work on growing your business. In addition, you won’t have to turn down incoming customers.
- Collections. The factoring company becomes responsible for collections and credit checks of customers. These administrative tasks will be taken off your plate which frees up some time.
- An Alternative to Banks. Banks have rigid and strict requirements when it comes to financing which isn’t always an option for some businesses. Using invoice factoring is a good alternative when businesses struggle to qualify for traditional financing.
- Commitment. Many factoring companies require a certain level of commitment, usually a year or more. They often aren’t willing to work with a business for a one-time occurrence. Some businesses don’t want to be locked into a long term contract.
- Expense. Invoice factoring isn’t free which adds to your bottom line.
- Potential Loss of Customers. Some customers don’t want to work with a third party when it comes to payment. They may not understand what factoring is or may see it as a sign of financial distress. Regardless, customers may be turned away from businesses that use invoice factoring.
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When Should You Work With Factoring Companies?
Working with a factoring company is ideal if one or more of the following is true:
- You don’t qualify for traditional financing with a bank
- Your customers pay within net 30 to net 60 days
- Your goal is to grow your business
- Your commercial clients have good credit
- Slow accounts receivable payment is causing cash flow problems for your business
Requirements For Working With Factoring Companies
Most factoring companies have requirements to work with them, thankfully they’re quite simple. Below is a list of common requirements to work with factoring companies.
- Profit Margins. As a rule of thumb, your profit margins should be between 10% and 15%, due to the cost of factoring.
- You Must Operate a Business. Factoring companies only work with businesses, including sole proprietorships and partnerships. However, many factoring companies prefer to work with corporations and other separate legal entities.
- No Liens or Encumbrances. Invoices pledged as collateral with other institutions cannot be used for factoring. Banks often put “all assets” as a lien for any type of funding. If this is the case with a bank or any other institution, you can’t factor your invoices. The only way you can factor your invoices is by getting the institution to agree to subordination. Tax liens or legal judgements can restrict invoice factoring opportunities as well.
- No Open Bankruptcy. Factoring companies do not usually work with individuals or companies with open bankruptcies. The process is too complex and expensive.
- Commercial or Government Clients. Factoring companies cannot purchase accounts receivable from retail accounts. Some of your accounts receivables must be from commercial and government clients to be eligible.
- Good Commercial Credit. Factoring companies will only want to purchase invoices that are likely to be collected. Having good commercial credit is the primary method factoring companies use to determine the quality of an invoice.
Costs Involved When Working with Factoring Companies
Factoring companies make money through factoring fees on each collected invoice. Each factoring company has a unique fee structure so the cost can vary from company to company. Some companies charge a one time fee based on the monthly volume of invoices and creditworthiness of clients. Other factoring companies charge additional fees for money transfers, collateral, and other operation costs.
Before signing an agreement, make sure the fee structure is clearly defined and you understand what the payment terms are. Not only will this help you predict future costs, but you’ll also ensure that you’re working with a reliable and consistent factoring company.
Factors to Consider When Working with a Factoring Company
During the process of selecting a factoring company, there are several key points you’ll want to consider before moving forwards. These factors are listed below.
- Advance rates in your industry
- Specialization of your business
- Fee structure
- Years in the business
Financing Through Factoring
Factoring is a great financing solution for many businesses, especially startups, struggling businesses, and small companies. If invoice factoring seems like the right decision for you and your business, ensure that you understand the agreement before moving forward. Your cash flow will improve and you can work on growing your business through factoring.
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