Does the term factoring bring to mind an X-Factor spin off? Perhaps the combination of factor and finance conjures up your own personal episode of Fear Factor?
While it doesn’t involve reality TV, factoring can improve the reality of your business. If your business has receivables, then factoring is a way to get cash quickly.
What is Factoring?
In its simplest form factoring is the sale of accounts receivable (money due to a business) at a discounted rate to a third party (the factor) as a means of financing (i.e., obtaining cash to help you manage your business). Still too much financese? Let’s walk through an example.
A web design company has just finished overhauling a large client’s website. The total fees for the work performed are $50,000. To win the business, the web design company allowed for a Net 90 payment arrangement with the client. That means the client has 90 days after the work is completed to pay their bill, and no interest or late fees will apply.
The web design company now has an account receivable of $50,000. Looks great on paper, but they need cash. Rather than waiting 90 days for their money, the web design company sells the invoice to a factoring firm. The web company will receive the cash minus a fee within a few days, in some cases it can even be the same day.
From the small business owner’s perspective it is similar to taking out a short term loan. The only difference is that their client is the one who will pay it off. Other terms used to describe this type of arrangement are Invoice Funding and Accounts Receivable Financing.
Factoring – The Good
Your business credit doesn’t matter. Your personal credit doesn’t matter. The age of your business doesn’t matter. Your mom’s credit doesn’t matter (just making sure you were paying attention).
The only credit that matters is the company that owes you money.
Why is that such great news? Your company could be six weeks old, yet if you have a verifiable Account Receivable with an established, credit worthy company, you will likely qualify for factoring. Try taking a six week track record into a bank and walking out with a loan.
If you do qualify for factoring, you should be able to access the cash quickly. For companies in a cash crunch, this could be a lifesaver.
Factoring also allows you to be more competitive on payment terms when bidding for business. Big corporations often expect Net 30, 60 or 90 terms. Without factoring your cash flow may not be sufficient to provide that payment schedule, costing you new business.
Finally the minimum amount of the invoice can be fairly low. While $10 isn’t going to cut it, $1,000 might be of interest to some factoring firms. A great place to start your research in finding a firm that would suite your needs is http://www.factoring.org/.
Factoring – The Bad
Factoring is only available on work that has already been completed. If you win a big contract and need capital to execute the contract factoring will not help you.
The Account Receivable must be verifiable. Handshake deals are not going to qualify. This is yet another reason why you should always have a contract when you do business.
The client must have good credit. Wait, Nicole just a few minutes ago you were raving about using the client’s credit. Yes, as long as their credit is good. No factoring firm is going to pick up your receivable if the client is only six weeks old.
Time and time again I see small businesses and entrepreneurs extend credit when they shouldn’t. If you are planning to use factoring to manage cash flow speak with the factoring company first. Find out if your potential client would even qualify. If they don’t I strongly recommend you don’t offer them credit either.
Factoring fees vary widely, so do your homework before partnering up with a firm. Some industries, such as construction and medical, will only do a partial payment up front. The balance is then paid when the factoring firm receives payment from the client.
Are you starving for cash and sitting on a pile of receivables? Does factoring sound like it might be your solution? Have you used factoring before? What was your experience?
