You’re probably familiar with the cash crunch dilemma: Business is going great, you’ve soared over your sales goals, and you know your clients are reliable and will pay on time. The problem? You've got bills coming due soon. And your suppliers aren't particularly interested in hearing what an outstanding month you've had or how good you look on paper.
So now you’re investigating your options and accounts receivable factoring looks appealing. But, like most things in life, it has its upsides and downsides. So, if you’re wondering if factoring is right for your business, here's what you need to know.
Accounts receivable factoring, or invoice discounting, is a form of financing in which a business sells its receivables to a company (called a factor in industry lingo) at a discounted rate.
"You're basically selling the rights to your receivables or invoices at a discount," says Will Howard, Foro's Vice President of Relationship Management. "So you get a cash lump sum today from a factoring company in exchange for your receivables."
Here's how factoring works: You sell your unpaid invoices to a factoring company at a discount rate. The factoring company will give you a cash advance that’s typically between 75% and 95% of the total. This advance rate is largely dependent on the industry. For example, construction receivables are factored with advance rates of 70% to 80%, while staffing and transportation receivables get a higher advance rate of 85% to 95%.
The factoring company then takes over collecting on your invoices. Once they've collected the payments, you'll receive the difference between your advance and the total amount of the invoices minus a factoring fee. Depending on how the arrangement is structured, this factoring rate, typically between 1% and 4%, will be applied to either the amount of your cash advance or the total face value of your invoices.
Let's say you have unpaid invoices totaling $100,000 that won’t come due for 30 days, but you need the money now. You decide to enter into a factoring arrangement with Factors R Us.
Under the terms of this agreement, you’ll get a 90% cash advance, and Factors R Us levies a 1.5% monthly factoring fee on the total face value of the invoices. So Factors R Us will give you $90,000 now, and when they've collected on your invoices, 30 days down the road, you'll get the remaining $10,000 minus the factoring fee:
1.5% factor fee = $100,000 X 0.015 = $1,500
$10,000 - $1,500 = $8,500
After this factoring arrangement, you'll have received a total of $98,500 for the $100,000 worth of invoices you sold to Factors R Us.
While factoring is often confused with bank loans and lines of credit, factoring arrangements aren’t “factoring loans.”
“Factoring is very different from a working capital line of credit," Howard says. "With a line of credit, you hold on to your receivables. What you're basically saying to the bank is, you'll provide me with financing based on a percentage of my receivables."
With factoring, you're actually selling your receivables, which means you're relinquishing your right to collect on your invoices. This nets you an immediate cash advance, but the factoring company takes on more risk. "This risk means the cost of factoring will usually be more expensive than a line of credit," Howard notes.
Let's say the bank offers you an operating line of credit at an annual rate of 10%. At first glance, this looks a lot higher than the 1.5% factoring fee you're charged in the example above.
But it's not a straight comparison between 10% and 1.5%. You need to convert that 1.5% monthly factoring fee to an annualized rate — and, as it turns out, a 1.5% monthly rate equals an annual rate of 19.56%.
In practice, there are several ways to structure a factoring agreement — and how an agreement is structured will impact your total factoring costs.
Factoring tends to be more commonly used in certain industries. For example, a staffing agency will need to meet its weekly or biweekly payroll costs, but, depending on the payment terms it offers its clients, there might be a long gap between when it sends its invoices and when it gets paid. In addition to the staffing industry, other industries in which factoring is common include the transportation, oil and gas, and construction industries.
It’s a good idea to know how a factoring agreement could benefit your business and what disadvantages you might have to deal with.
Small businesses usually consider turning to factoring for help with cash flow problems. But there are alternatives:
For many small business owners, cash flow issues can be challenging. And while accounts receivables factoring may be a viable solution, it's important to understand the disadvantages as well as the benefits of factoring so you can make the right decision for your business.
The costs of factoring receivables will vary depending on the terms of your factoring arrangement, but factoring will typically be more expensive than more conventional financing.
The main advantage of factoring receivables is faster access to funds. Other advantages include easier approvals and more flexibility than a line of credit.
Depending on the factoring arrangement, you could remain liable for unpaid invoices. Other risks include the potential impact on your customer and banking relationships.
If you're selling your receivables to a factoring company, the money you receive from them is considered income which you will have to report. However, you should always consult an expert if you have any questions about the tax aspects of factoring.
Belle Wong is a freelance writer specializing in finance, tech/SAAS, small business and marketing. She spends her spare moments testing out the latest productivity apps and plotting her latest novel. Connect with Belle on LinkedIn.