Learn about best practices to manage cash flow.
Extending credit is a great way to encourage sales. But while you wait for the customer's payment, you have real needs for that cash: inventory must be replenished, overhead costs aren't on layaway and need to be paid, and employees expect their paychecks at the same time every pay period. But where will the cash come from?
Let's say you've made the sale and the customer has taken possession of your product or service, agreeing to pay you for it in a specified time period. You enter an accounts receivable entry in your business's books, awaiting the payment.
Factoring is the sale of accounts receivable, as opposed to borrowing against them as you would do in accounts receivable financing. By selling your invoices, you generate cash immediately instead of having to wait for your customers to pay you. This can be beneficial to your cash flow situation.
The seeds of the modern factoring industry were sown in the 15th century, that hectic era of Joan of Arc, the birth of the Ottoman Empire, the War of the Roses, and--who could forget?--Columbus' discovery of America? Factoring evolved along slightly different paths in Europe, Britain and America, so the 21st century version described in this article refers specifically to factoring American-style.
Accounts receivable represent sales that have not yet been collected as cash. In the worst-case scenario, unpaid accounts receivable will leave your business without the necessary cash to pay its bills. Accounts receivable also represent an investment, which means the money tied up in accounts receivable is not available for paying bills, paying back loans, or expanding your business. This can all be summed up as a lack of liquidity. Your business can make a substantial profit but still suffer illiquidity. Got constipated cash flow. . .? No worries. . . call a factor!
Commercial finance companies, somebanks, and a variety of other types of financial companies will often factor receivables. For businesses with relatively small accounts (e.g., less than $10,000), it may require some effort to locate a factor company willing to purchase low amount receivables.
The good news is that the factor company that purchases your receivables takes title to the invoices and collects them when they are due. That company also assumes responsibility for all of the costs, as well as the hard work and hassle that comes with customer debt collection.
The bad news is that factoring is not cheap; the cash price of the accounts receivable is rather heavily discounted by the factor company. Factoring is generally used by rapidly growing businesses that face temporary cash flow problems. Except in certain industries, factoring is not generally used on a long-term basis.
The advantages to factoring include:
The disadvantages to factoring are:
Factoring agreements can be quite flexible, and you should always try to negotiate for the best terms possible. Renegotiation for a lower discount percentage is common in ongoing factor relationships; however, the most negotiable charges are often not the initial discount percentage, but other additional charges (such as a fee for expedited wiring of your cash price or an initial user fee) assessed by most factor companies.
As an alternative means of filling a short-term gap in cash flows, factoring can be an effective--albeit sometimes expensive--solution. One way to be in a strong position to negotiate with a factor is to plan ahead and anticipate your cash gaps so you’re not ambushed by a crisis.
If a cash flow crunch does happen, remember that you have options. And factoring is an overlooked one.
Get what you need when you need it. ADP's small business expertise and easy-to-use tools simplify payroll and HR, so you can stay focused on growing your business.
Start your business with confidence. We offer various incorporation packages to get your business up and running. Starting from $99 and includes 6 months FREE Registered Agent services.