Factors to Consider Before You Hire a Factoring Service

Let’s say you have a client that owes your business $100K. The client’s business has a solid credit history, but it also has a policy of not paying its suppliers for 60 days. You have two choices: you can wait the full two months to receive payment, with all of the anxiety the waiting game entails, or you can turn to a company that specializes in a service called “factoring” and receive 80 percent of the owed amount in two to three business days.

Sound too good to be true? It may be, depending on the needs of your business. It may also be the stop-gap payment solution your business needs to get through a difficult time. As is the case with most financial instruments, certain conditions apply. Let’s examine them more closely.

First, what, exactly is factoring? It is a type of debtor finance in which a business sells the value of its invoices to a third party (i.e. the factor) at a discount. Companies that suffer from the unfortunate combination of cash-flow deficits and slow-paying customers occasionally turn to factoring companies as a makeshift measure to meet their present-day liquidity needs. After checking the credit worthiness of the customer, the factor advances 80 to 90 percent of the invoice amount. When the bill is paid in full, the factor remits the balance, minus a service fee.

Factoring is nothing new. Large corporations have long used the service to increase cash reserves and/or reduce the management of receivables. What’s changed is that these days the practice is becoming increasingly popular with small- to mid-sized businesses as well. According to the Wall Street Journal, billions of dollars flow through factors each year, many of which specialize in particular industries such as staffing, trucking, and health care.

Is factoring a creative way to bolster your small business’ liquidity, or a slippery slope that could trip up your profit margin? Let’s review a few of the most significant “factors” both in favor of and against the practice.

The Pros:

• The biggest upside to factoring is that your business gets paid quickly – within 24-48 hours, wired to your bank account – rather than the typical 30 or 60 days. (If you’re waiting more than 60 days to receive payment for services rendered, you have another problem altogether.) As a result, many companies with low capital reserves rely on factoring to make ends meet while they’re waiting for payment.
• Factoring can be a genuine lifesaver to businesses that are just starting out, particularly if they have intensive working capital needs. Raising capital typically involves approaching a lender, but that’s not always a viable option for a new business without a viable credit history. That’s where factoring comes in. Unlike banks, factors don’t focus on a business’ creditworthiness before issuing a loan; they focus on the financial soundness of its customers. If your business is in its infancy, selling your invoices may help you achieve the capital reserves you need to stay afloat while you build market liquidity.At the same time, factoring can actually increase your company’s credit score, because there’s no loan, and no loan to pay back.
• It’s a fairly straightforward process. Factoring services typically require less paperwork than other lending agents, such as banks, and they can be less demanding than outside investors, who may go so far as to require a piece of the business in exchange for the loan. Factoring also gives you the option of working with more than one “lender.” You’re not married to a financial institution the way you are when you borrow from a bank.
• Not only do factors offer advances against your receivables, they process the receivables themselves. This helpful service gives business owners the option of outsourcing the company’s accounts receivable function.
• If you are considering expanding your business overseas, many factors already have extensive experience dealing with overseas suppliers, which can make the transition to international commerce that much more seamless.

The Cons:

• Factoring can be expensive, typically 2.5 to 3.5 percent of the invoice amount per 30 days, which is a higher rate of interest than the average unsecured line of credit. Accordingly, it may be too expensive to justify for businesses that rely on smaller-denomination invoices.
• The factoring industry suffers from a “perception problem”; that is, in many instances, companies that use the service are deemed to have liquidity troubles of their own. So, while factoring customers don’t have to worry about billing and credit checking or the staffing requirements to handle these concerns, they may have to worry about how clients will perceive having their transaction handled by a third party.
• Pay close attention to the small print. Specifically, make sure you know whether you are selling your receivables “with recourse” or “without recourse.” If it’s the latter, the factoring service itself is liable for any uncollected balances; if it’s the former, you are.
• Does factoring fit your profit margin? Here’s a simple rule of thumb: If your margin is 30 percent or higher, the service may well make sense. If it’s in the 10 to 15 percent rage, it might end up costing you more money than its worth.

A Useful Service, Under the Right Circumstances

Leveraging the accounts receivable ledger certainly isn’t for everyone, but it may make sense in the right situations. It may even spell the difference between success and failure for your business. The fact is, companies that have low working capital reserves can develop serious cash flow problems if too many invoices remain outstanding simultaneously. If a bank loan isn’t an option for your business, factoring just may be the white horse that rushes in and saves the day. If you can tailor the factoring fees to meet the individual needs of your business, you’ll be that much further ahead.