A big problem companies often face is in their cash flow. When customers pay their bills too late, this can result in a cash-flow shortage. Not having ready access to cash can stall a business that needs to grow quickly. Many owners turn to accounts receivable factoring to get money for their business. (It can be faster than waiting the 30 to 90 days for their customers to make payments.) The accounts receivable factoring company pays the company—usually about 85 to 90 percent of the outstanding invoices. Then the customer pays the company.
Seems simple? It’s not. Consider these guidelines to help you determine when is it safe to use accounts receivable factoring. If it’s not a good fit, you may want to turn away from this financing method to seek alternatives.
When Accounts Receivable Factoring May Make Sense…
In many cases, accounts receivable companies can get cash to the business within 24 hours. This can help if the company can’t wait or qualify for a traditional bank loan.
“Remember that accounts receivable factoring is not “easy” money, but can be an appropriate form of a short-term loan under the right business conditions.”
If accounts receivables are growing rapidly, and the cash needs to be invested now to specifically grow the business in the next few months, this form of financing can be effective for a short period of time. It also can be appropriate when the business does not want to take the risk of collecting the receivables from the customer, which happens often in the retail clothing industry.
Since this payment is an advance, it does not appear as debt on your balance sheet, but it can build your company’s credit score.
… And When Accounts Receivable Factoring May Not Work
If factoring isn’t done at the right time, it can get the company in even more cash-flow trouble.
Remember that this method is expensive. Even if the rate is 10 percent (as in, you’re getting 90 percent of the invoices in cash now), then your company is paying a 10 percent interest rate for perhaps 90 days’ early payment of cash. This can be a whopping 40 percent interest a year!
The factoring company also contacts your customer and tells them that the payment should be made to them. This may have a negative effect on the customer if it is not explained correctly.
If your accounts receivables and sales are shrinking, this form of financing can be trouble for the business since they are in effect borrowing from a bleaker future. In addition, most factoring loans have full recourse—so if the customer doesn’t pay their invoice, the money needs to be returned.
READ MORE: 4 ways to attract funding for your startup
What to Watch Out for
If you’re considering accounts receivable factoring to grow your business, keep an eye out for the following:
The term: How long do you need to use the factoring company for? I think the best case is not to have a long-term commitment. Utilizing individual invoices when cash is actually needed can be better.
The rate: What discount rate are they charging? Remember, whatever discount they take off of the accounts receivables is the effective interest rate they are charging you for the period of time the advance cash is used. To repeat, if the rate is 10 percent for customers that usually pay in 90 days, then the annual percentage interest rate is 40 percent!
Additional costs: There can be additional costs besides the discount rate. Some accounts receivable factoring companies charge a set-up fee and a weekly interest fee until the customer pays their invoice.
Reserve account: Some accounts receivable factoring companies build a reserve account by holding back a little cash from each invoice. This is done in case an invoice is not paid. Remember, this means a higher discount rate and more money that you are not able to use to grow your business.
Remember that accounts receivable factoring is not “easy” money, but can be an appropriate form of a short-term loan under the right business conditions.
Credit: Open Forum Blog