Small Business Financing Using Accounts Receivable
What is Factoring
Factoring refers to the process of selling your accounts receivable invoices to a third party who then performs the function of collecting the invoice. Called factors, these agents can move quickly to get funds to a business for a fee as a means of providing financing for growth. Most factors initially pay you in two stages; the majority (70 to 90%) up front on the initial advance and the balance when the invoice is collected, through the reserve release . Factoring fees range from 2% to 5% or higher depending upon a number of variables (see factoring fees).
Why (and when) factoring?
Cash flow is king in a business!
80% of business failures can be attributed directly to a lack of cash flow and/or working capital. A business may be growing leaps and bounds, but if monthly sales invoiced do not produce cash on time to pay wages or creditors, it may still fail from being cash starved.
Factoring allows a business to sell invoices to a third party, a factor , at a discount in return for cash advanced before the invoice comes due. In addition to the benefit of having cash on hand sooner to support operational expenses and growth, factoring does not usually tie up assets outside the business, does not involve the repayment of debt at some future point in time or if called on a certain date, and frees up internal resources normally devoted to tracking and collecting Accounts Receivables.
Factoring can be an attractive tool for many businesses but may be most appropriate for rapidly expanding operations. For example, it takes time to get an increase in a traditional bank line of credit. However, time is usually of the essence when a large order is received and requires additional financing for raw materials. Other less routine situations include; management buy-outs, acquisitions and restructures, turnarounds and delinquent tax situations. Business start-ups that have sufficient accounts receivable volumes and sales turnover levels will also find factoring a valuable financing tool.
While there is a cost to your business when you factor , this cost, or a portion of it, should be built into the cost of sales and/or be justified in terms of the value that the advanced cash on hand represents to your operation. Often businesses are able to increase prices or take advantage of supplier discounts and benefit from the enhanced purchasing power the additional capital provides them. In general, the following variables determine factoring fees:
- Risk: refers to the credit worthiness of the account debtors (your customers).
- Maintenance: refers to the work involved in managing your receivables. In other words whether you have a large number of small invoices or a smaller number of large ones.
- Time: refers to how long your customers take to pay. Time is money after all.
- Volume: plainly stated means the higher the volume the lower the fees.
Any Factoring company that quotes you a rate without knowing all the particulars of your business is doing you a disservice and wasting your time. There are details that will not only determine the best factoring rate but also the services required to ensure its success. If factoring does not solve the problems it was intended then the expense would be much higher than anticipated.
Factoring fees do not vary much from factor to factor but they are often presented in radically different ways. They can be stated as; a one time off the top discount fee, a daily discount rate or even as a fee with a rebate. Clarity and track ability are important issues to consider. The end result should be a discount off the invoice similar to the merchant fees that credit card companies charge to their retail establishments.
Some innovative factoring companies have developed Asset Based Lines of Credit that incorporate the best of factoring (full accounts receivable management) and a line of credit (low rates charged only on the money borrowed). Qualifications would typically be higher. Fees are split between a Collateral Management fee and an interest rate on the monies borrowed.
Who Uses Factoring
There are many different types and sizes of businesses that find factoring a beneficial cash flow management tool. The key factor is to weigh the cost against the benefit of having the cash on hand sooner rather than later.
Qualifying for Factoring
The following characteristics are viewed when a business is evaluated as a factoring client:
- Businesses owner's knowledge of and experience in their industry
- The credit worthiness of the businesses customer base, and
- The strength of the businesses receivables
Factoring vs. Bank Financing
Factoring can be a valuable alternative for securing vital working capital, when a bank may be unable to provide financing due to some of the following situations:
- Start-up business with a limited track record
- Rapid growth drives consistent increased capital needs
- History of operating losses
- Minimal or deficit net worth
- Tax liens in place
- Past personal/business bankruptcy or credit issues
Banks operate with tighter credit parameters due to the fact that they are operating with depositors funds or borrowed funds from the Federal Reserve. It is this fact that requires them to be more conservative with their lending practices.
Factoring for New Businesses
Relatively new businesses often require a high degree of funding flexibility where credit history is limited yet the promise of substantial growth requires substantial cash flows. Factoring can often be the ideal solution under the following common new business challenges.
|Common New Business Challenges||Solutions||Where to Get Help|
|Can't get a credit line||Factoring offers a means for securing cash advances against outstanding invoices without tying up personal assets or giving away any ownership or equity position.||Learn More
|Limited capital to fund operations and marketing.|
|Large order requires additional funding|
|Seek investment capital without giving up ownership/equity|
|Need to understand financing alternatives|
|Limited resources to properly manage accounts receivable|
|Vendor credit is not available for funding growth|
Collecting money due from customers may be one of the most critical aspects of ensuring cash flow to support growth. As a small business, it can be profitable to rely on a factoring agent to perform this role in a professional and timely manner helping you to overcome the following common business challenges.
|Common Accounts Receivable Challenges||Solutions||Where to Get Help|
|Afraid to ask customers for money||Factors provide valuable services to validate customer creditworthiness such as credit analysis, credit guarantees and collection management to ensure that you're paid in advance and that your customers are satisfied.||Learn More
|Limited time and skills for developing a professional and consistent collection process|
|Don't have the staff to handle collections|
|Need to eliminate bad debt accounts|
|Desire quick and accurate account reporting|
|Need to access cash faster|
|Desire to improve credit rating|
|Want to eliminate COD Deliveries|
|Conflict between selling and collecting demands|
Optimizing Cash Flow
More businesses fail through lack of cash flow than for any other single reason. Below are areas where having a lack of cash flow can seriously compromise the success of a business and how factoring can help:
|Common Cash Flow Challenges||Solutions||Where to Get Help|
|Taking advantage of vendor discounts||Factors advance cash to you against invoices at the time you have shipped the goods or completed the services so that you can fund purchases, payroll, seasonal expenses and other operational expenses.||Learn More
|Not risking the loss of vendor credit lines|
|Ensuring payroll is covered|
|Improving control over accounts receivable cycles|
|Avoiding morale problems when cash is tight|
|Miss short-term opportunities|
|Need vendors to be more responsive|
|Must reduce Days Sales Outstanding (DSO)|
Calculate the difference between profit over a one year time frame with and without using factoring using a Financing Spreadsheet Tool
Purchase Order Financing
Purchase Order Financing is used when a business does not have sufficient capital to produce an order. This situation can be common for start-up manufacturers or when a large order is received. There are two types of financing solutions that a factor can provide in these situations:
- Factor provides the client's supplier with a Vendor Assurance Letter that confirms that the supplier will be paid directly by the factor upon shipment of the order and presentation of the invoice to the factor.
- Factor provides the client's supplier with a Letter of Credit that guarantees that the supplier will be paid directly upon delivery of the order.
There are a broad range of challenges faced by many small business owners when dealing with growth that a factoring relationship can productively assist with:
|Common Growth Challenges||Solutions||Where to Get Help|
|The more sales you make, the more money others owe you, and the more you need to quickly collect to fund more sales||Through factoring , cash against existing receivables can be made readily available to fund marketing, purchase technology, expand market share, improve vendor confidence and support other working capital needs.||Learn More
|Increased marketing costs to support sales momentum|
|Need to secure larger vendor credit lines|
|New technology requirements for better efficiency|
|How to fund growth without giving up equity|
|Opportunity to expand globally|
|Narrow window of new sales opportunity|
|Limited credit line availability or capacity|
10 Great Reasons to Use Factoring
Factoring can be a powerful financing tool
- Accelerate cash flow - Factoring allows you to sell invoices to a third party at a discount, so that you receive the cash you need now to support operational expenses
- Financing alternative - Factoring is a powerful funding tool for supporting growth
- Fast payment turnaround - Factoring is simple to use where an invoice outstanding can be turned into cash on hand in as little as two days
- Simple to use - It is relatively simple to set up a factoring relationship
- Ready cash - Factoring means "ready access to working capital."
- Leverage staff time - A factor provides value-add services to ensure that who you do business with is creditworthy
- Professional Visibility - Factoring improve your business position with customers as the quality of products/services delivered is validated by a third party and invoices are collected in a professional and consistent manner.
- Success Factor - Using factoring is viewed by customers, vendors and the factor as a positive growth step to the ongoing success of your business
- Funding Capacity - Factoring does not tie up other assets as collateral as with other forms of business financing
- No funding limits - There is no limit to the amount of factoring where all qualified invoices offer advanced, discounted cash flow.
Where to Begin
Establishing a new factoring relationship typically involves 5 to 7 business days whereby you will work with a Business Development Officer (BDO) at the factoring organization in submitting an application and financial information along with invoices to be factored. Upon acceptance, a Security Agreement is signed, a UCC-1 is filed as the appropriate collateral, the customer(s) is notified that invoice collection will be direct to the factor and you will receive the discounted advanced cash.
As an ongoing client, invoices are submitted using a signed Schedule of Accounts, customer credit is verified accordingly and the cash advance is made.
To begin establishing your own factoring relationship, consider the following options:
- Call toll free 1-800-757-5895, or
- Download Factoring Application
- Download Personal Financial Statement
- Download Company Financial Statement
About Your Sponsor
"The Commercial Finance Group (CFG) provides working capital financing for small to medium sized businesses and specializes in assisting companies that are unable to qualify for adequate bank financing. By providing credit approval on orders, administering invoices and lock boxing payments, CFG has the flexibility to finance businesses that are undercapitalized, or in a start-up or turn-around situation."