Every day, businesses are turned down by the once trusted bank system that used to feed our young, growing companies. It seems that a business has to have a perfect scorecard to get the golden bank loan that was once in every business’s toolbox.
Today, a business must have an A+ balance sheet and income statement. And if you’ve only been in business for a year, then forget that bank loan. What does a business do nowadays to fund the growth and expansion of a cash-hungry business?
The rising trend is found in a niche financial industry called invoice or receivables factoring.
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What is Invoice Factoring?
Invoice factoring is the combination of an accounts receivable service and cash advance. A factoring company buys the invoices or accounts receivable of a business to provide the cash necessary for working capital. Instead of waiting 30, 60 or 90 days to collect their receivables, businesses can hire a factoring company to buy its receivables and provide immediate cash.
In 2013, total worldwide factoring volume was $3 trillion, according to Factors Chain International. The recent annual growth rate has been 10 percent. Factoring has risen in popularity as bank loans have slowed due to stiffer regulations.
Invoice Factoring Diagram
The History of Invoice Factoring
Factoring originated in the 4th century BC. Factoring became a prevalent business practice in England and made its way into America in the 1600’s. Factoring has always facilitated trade by financing transactions between buyers and sellers. In the 1900’s, factoring was predominant in the textile industry. Large transactions required a third party factoring company because banks were too small to finance them.
Today, factoring not only services manufactured goods, but services as well. This model has opened up all types of industries to factoring, including professional services, transportation services, staffing operations, construction companies, government contracts, as well as almost any business-to-business transaction.
Can Factoring Help My Business?
Factoring companies buy invoices and receivables from businesses that deliver goods or services to other businesses (B2B). It’s very difficult to factor retail or B2C transactions. The factoring company relies on the credit strength of the buyer.
“The buying company must be a credit-worthy customer”, says Lisa Hultz, VP Sales at Mazon Associates, Inc. If a roofing company provides services to residential homes, then it won’t qualify for factoring. If the roofing company provides services to commercial customers, then it will qualify.
How Does Factoring Solve My Financial Problems?
Factoring is a unique form of financing. It’s not like debt or capital financing. The factoring company buys the invoices for cash. The immediate cash speeds up the seller's cash flow because they don't have to wait 30 to 90 days for collections. Quicker cash flow or a shorter cash cycle can do wonders for your working capital.
Rather than taking on additional debt from a typical bank loan, factoring can speed up existing working capital and achieve similar, or better results. Unlike a bank loan, the business isn’t encumbered with repaying debt.
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What if an Invoice Doesn’t Get Paid?
Typically, invoice factoring is performed on a recourse basis. That is, if the factoring company cannot collect a receivable within usually 90 days, then the factoring company will go back the seller to retrieve the funds. The factoring company has recourse against unpaid invoices.
A business can choose to sell its invoices under a non-recourse factoring agreement. With non-recourse, the factoring company is liable for any unpaid invoices. The customer’s inability to pay must be the result of bankruptcy or insolvency.
If a business ships damaged goods under a non-recourse agreement and the customer doesn’t pay because the goods are poor quality, then the business, not the factoring company, is liable for the non-payment.
This Sounds Really Great, What Does it Cost?
Factoring companies provide up to five different services for their clients:
- Credit services on business customers: checking customer’s ability to pay.
- Accounts receivable management: posting payments; daily and monthly reporting.
- Invoice verification: making sure the receivable is valid and collectible.
- Receivables collections: collection calls, receiving payments, managing aged accounts.
- Non-recourse factoring (optional): the factoring company assumes the risk of collections.
The cost of factoring is either expressed in a single rate or a combination of rates, one for the services and another for the financing or interest. Many times, a factoring company charges a flat monthly rate. Other times, factoring companies charge a lower rate for the first 30 days, a higher rate for the next 30 days, and so on.
Sometimes the rates step-up every 10 days, instead of 30 days.
Typical factoring fees range from two to six percent of the invoice amount. Larger invoice amounts receive lower rates. Complex and riskier invoices require higher rates. This may appear to be a high rate, but remember there’s more than just financing in the deal.
A business can literally outsource its A/R Department to a factoring company and save a bundle in payroll costs and service fees.
Should I Factor My Invoices?
This is an easy question and involves simple business finance. If the income generated from factoring invoices exceeds the opportunity cost of not factoring, then you should consider factoring. For instance, if ABC Equipment Co. has an opportunity to sell a shipment of equipment for $10,000 net profit and the factoring costs on the invoice is $4,000, then it makes sense to factor and sell.
An intangible benefit of factoring is keeping valuable customers. If the business isn't able to sell services or goods, then potential customers will look elsewhere in the future.