Managing Cash Flow

Learn about best practices to manage cash flow.

Solving Serious Cash Flow Shortages

Factoring your accounts receivables can fill in gaps in your cash flow. We review some key things you should know before you enter into this method, and discuss where you can find a factoring company.

If cash flow is a serious problem for your small business or you're looking for quick cash to expand your business, you may want to consider factoring your accounts receivables.

An Introduction to Factoring

Are you familiar with factoring? If not, it's a form of financing for small and medium-sized businesses whereby you "sell" your accounts receivable to a factoring company at a discount. It's a $70 billion industry in the U.S. and a $250 billion industry worldwide.

Although the terms you'll get will vary from company to company, factoring contracts all have the following elements in common:

  • Advance rate. The advance rate is the percentage of your accounts receivables that companies will advance to you. Some companies will advance you the full 100 percent up front. Others will advance you, say, 70 percent, and then will pay you the balance once the receivables are collected. The typical range for how much they'll pay in cash up front is 60 to 90 percent of your account receivables.
  • Discount rate. The discount rate is the fee charged by the factoring company for the financing. The typical range is 2 to 7 percent of your accounts receivables, although I have seen as low as 1 percent.
  • Recourse vs. nonrecourse. In a nonrecourse agreement, the factoring company bears the burden of collecting the accounts receivable. In a recourse agreement, the small business owner bears the burden (in other words, if they are uncollectable, they will be charged back to you). Obviously for a small business owner, the nonrecourse agreement is preferred, although the rates you'll get won't be as good as with a recourse agreement. You'll have to weigh one against the other. Just make sure that you understand whether your agreement is recourse or nonrecourse before you agree to the terms.

As with most financial arrangements, the terms and rates depend upon what the lending institution views as your credit worthiness. Small businesses with higher sales volumes or with what are viewed as stronger account debtors get better rates than those with small sales volumes or more questionable account debtors. Thus, the smaller the business, typically the worse the terms.

If you're interested in factoring, the first question you should be asking yourself is: Why don't I just get a bank loan and use the accounts receivables as collateral? The answer is "you should"- if you can get a bank to loan you the money. Bank fees will typically be much lower than factoring fees, and you should definitely pursue that option if it is available to you.

But factoring companies are betting that most small businesses can't easily get loans from banks these days, particularly those with a troublesome cash flow history. And judging from the size of the industry, they appear to be winning their bet.

The factoring companies also believe they can outperform the banks in one other area -speed. "Factoring provides cash in 48 hours or less after an account is set up," says Paul Chapman, founder and president of American Certified Factors, a worldwide factoring company based in New York. "The account setup typically takes about seven days, but often we can provide access to funding immediately."

You'll just have to crunch the numbers to figure out if factoring makes sense for your business. Ask your lawyer or accountant what they think about factoring. And ask some of your business associates for their experiences.

If you're interested in pursuing this further, there are literally hundreds of factoring companies all around the world, and most have web sites. Before you choose a company, make sure that you shop around for the best rates.

Category : Managing Cash Flow
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