Accounts Receivable factoring, or AR factoring, is not a new cash flow management technique, even though it might be new to you as a business owner.
Small-business owners don't start their companies to be short-term loan officers for customers. But when your business allows customers to pay on 60 or 90 day terms, that's effectively what part of the business becomes -- and sometimes that means hiring or subcontracting with a collections company to make sure you get paid. So not only is your business not getting paid quickly, it's also incurring extra expenses to make sure that the agreed payment happens.
The cash flow problem most small businesses have is that they pay for all the materials to fulfill orders, then make and ship the orders, then ... they wait. And wait. They wait for the customer to make payment. Sometimes they wait as much as 60 or 90 days, and sometimes the customer skips town and doesn't pay at all. What if, in that 60-90 days, the manufacturer gets a huge order -- but without the money from that customer's payment there is no cash to buy materials to fulfill the new order? What can the manufacturer do?
1. Chase the customer to pay up early.
2. Let that second order slip away.
3. Find a way to get the cash to pay for materials for order #2.
Probably the quickest and easiest way for businesses to get money quicker is to sell the invoice to an Accounts Receivable Factor.
Here's a list of things you ought to know about AR factoring:
1. The Factor (the entity purchasing the debt) isn't interested in your ability to pay a debt. You are not under scrutiny -- the customer whose invoice you are selling is the subject of that investigation. To look at things from the Factor's side, would you knowingly pay to buy a debt which you knew the debtor could not pay back?
2. The debt is purchased at a discount, usually in the two percent to seven percent range. The actual amount will depend on how much debt you are selling, the payment history of each debtor, the length of time until payment is due, and the number of invoices that are being sold. A large invoice for a customer who pays on time and in full will be more attractive to Factors, and will probably have a lower discount rate.
3. There are two main kinds of factoring. A "full service" factoring deal will mean that the Factor has puchased the debt and the responsibility for collection. They also purchase the full risk of collection in the event of non-payment. "Recourse" factoring is different, and is riskier to you as the seller of the debt. If the debtor doesn't make good on the debt, and fails to pay the Factor, you'll be required to buy the debt back, or replace the debt with other invoices.
If you have sold an invoice for a customer who always pays on time and always pays in full, it's probably a better choice for you to use recourse factoring, since the risk is low. As a result you get a better discount rate.
4. Not having to wait for your customer to pay their invoices has multiple up-sides for you: faster cash flow can improve your financial statements and ratios, you'll have more money in your business to make other payments or invest in growth, being able to pay your suppliers early or on-time can improve your credit rating, and you could even reduce the size of your billing and collections department.
5. If banks ever get back to lending, and you have a good credit history, and you want to borrow enough to make it worth the bank's time, you could probably take a bank loan to fund your business growth. But that process can take a long time, but the loan increases company debts, and will likely be provided at a double-digit interest rate. Factoring puts all the scrutiny on the customers whose invoices you are selling, and many Factors will pay for the invoice in as little as three days. Factoring adds no debt to your balance sheet -- it just changes an accounts receivable item into cash.