Cash flow is central to the success of every business. As a business grows and needs to speed up cash flow, small businesses typically first turn to banks for financing. However, with tough credit standards banks cannot always fully accommodate a company’s financing needs. Alternative financing options, such as accounts receivable factoring, may provide the working capital the business needs.
Accounts receivable factoring is financing that comes from a business selling its accounts receivable to a factoring company or bank. The amount available generally depends upon the invoice volume.
What are the advantages and disadvantages of factoring over other forms of small business finance and why would a business use this form of financing?
Advantages of Factoring
LARGER AMOUNTS: Because accounts receivable factoring is based primarily upon accounts receivable, small businesses with large amounts of accounts receivable for goods or services sold to financially strong customers can often obtain a bigger line than they would qualify for with conventional bank lenders. This is because factoring is based on the credit strength of your customers. Banks look more at your businesses credit strength to support their loans. Consequently, often factoring companies can provide more financing more quickly than banks.
QUICKER SET UP AND FUNDING: Most accounts receivable factoring lines can be approved, set up, and actively funded in just a few weeks. Banks typically require more time to perform their credit review of your company… perhaps even waiting for upcoming fiscal period closes or audit results. The faster set up of accounts receivable factoring lines is because factoring companies have simpler more streamlined underwriting requirements.
Again, they are able to do this because they are relying significantly on the credit strength of your customers.
EXPANDS QUICKLY WITH GROWTH: Most factoring companies can expand their financing for you as fast as your business grows, even if your company has little track record performing that much business. Factoring companies have no bureaucracy hindering the increase of a line size. So you are not likely to “outgrow your line” as easily. Just be sure you have a factoring company big enough to accommodate your growth ambitions.
NOT A LOAN: A factoring company is not making loans. They are purchasing the accounts receivable with cash. This has the same result of increasing working capital but many accountants would not show this as a liability on the balance sheet the way a bank loan would appear. So factoring, instead of borrowing, reduces balance sheet debt resulting in a lower debt to equity ratio.
LESS COSTLY THAN EQUITY: In need of financing many businesses turn to equity investors. For some business investment and expansion purposes, there is no substitute for equity capital. However, most equity investors expect higher returns than the costs of accounts receivable factoring and new equity contributions dilute the ownership stake of existing owners often even shifting control. Most factoring arrangements have no dilutive effect on shareholders.
IMPROVES YOUR TURN: Many factoring companies verify invoices with your customers and follow up promptly if your invoices are not paid on time. These gentle reminders to your customers usually result in more timely payments and it frees you and your staff up from having to perform these administrative tasks to focus on your product or service delivery.
Disadvantages of Factoring
MORE EXPENSIVE THAN A BANK LOAN: Accounts receivable factoring is more expensive than bank financing because of the transactional work with the invoices the factoring company does to advance more money more quickly. Costs vary significantly between factors and comparing rates and fees can be challenging. Consequently, invoice factoring cost drivers need to be carefully understood.
SHRINKS AS BUSINESS CONTRACTS: Factoring can grow rapidly with you but also contracts as quickly if your business is contracting. So factoring may not be a good solution for businesses with great seasonality or other significant downward fluctuations in revenue.
NOTIFICATION: Factoring companies typically require that you assign the accounts receivable to them. This means that your customers’ accounts payable departments will be notified to send payments to the factoring company’s lockbox. Some businesses are concerned this will affect their customer relationships but factoring is such a commonly used form of financing that a professionally delivered factoring service rarely draws much notice from customers. Typically, the process is routinely handled in the Accounts Payable department. However, it is important to thoroughly understand the terms of a factoring agreement to know if costs or delays in payment may result from the notification process.
Weighing the advantages and disadvantages of factoring, bank financing is preferable over accounts receivable factoring, if banks can provide all the funds a business needs. If, on the other hand, a business is unbankable or does not qualify for a line of credit large enough to pursue growth opportunities, accounts receivable factoring is a good alternative financing option to supply the needed cash flow. Careful selection of a factoring company is essential to ensure accounts receivable factoring is professionally delivered and well-priced.
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