A Closer Look at the Pros and Cons of Factoring Accounts Receivable

If you’re finding that cash flow within your business is slow or stagnating, you know the frustration and worry that sets in. You have money – it’s locked up in those unpaid invoices from your customers. And, while they’ll eventually be paid, you’re faced with the decision of how to proceed in the interim (consider as a solution!).

You have significant needs for liquid capital now, not in 30, 60 or 90 days when your customers finally get around to paying their bill.

Factoring accounts receivable can be a good solution in this instance. and how does it work? It’s actually a pretty simple process. We’ll outline that for you below, and then dig into the pros and cons of factoring accounts receivable to help you determine if this is the best way for your company to grow.

What’s Involved with Factoring Accounts Receivable?

Factoring Accounts ReceivableFactoring has been around as long as one business has needed money and its customers were slow to pay. From the first time that a Carthaginian merchant sailed for the Iberian Peninsula, intent on selling bulk wine to customers there, factoring has provided an invaluable tool against slow payment.

As we mentioned, factoring accounts receivable is actually a very simple process. All you need is an unpaid invoice and a that will work with you. Essentially, you sell your invoice (or invoices, as the case may be) to the factoring company.

In return, you get an advance on a portion of the invoice total. This can vary from 70 to 90% of the invoice’s value. Once your customer pays the invoice, you’ll receive the balance, less the factoring fee (which should be discussed prior to signing a contract with the factoring company). You can use that money for pretty much anything – buy new equipment, stock new merchandise, buy materials for manufacturing, keep fuel in your rig and more.

Now, there are quite a few other considerations here. It’s not quite that cut and dried. You’ll need to make sure that the factoring company you’re working with is experienced with your industry, for instance. This is of particular importance for businesses in industries where expertise is crucial – think logistics, manufacturing, warehousing and distribution, and the like. A generalist factoring firm will not be a good fit for most companies. Instead, you need to find a specialist.

You should also consider the factoring company’s minimum, which is the smallest invoice amount they will purchase. You can sometimes offset this by selling multiple invoices at the same time, but that may or may not be the right decision for your specific business.

In the end, factoring accounts receivable can be an vital tool that helps you run and grow your business, but it’s not something you can go into blindly.

The Pros and Cons of Factoring Accounts Receivable

Now that you have a rough understanding of how factoring works in the first place, we need to address the pros and cons. You’ll find a lot of benefits here, but there are a few potential drawbacks that might limit factoring’s value to your company, or make it an unwise decision. As a note, most companies will find that factoring accounts receivable is highly beneficial, and can foster business growth with cash flow through your company stalls out, but there are caveats that must be addressed.

The Pros

You’ll discover a lot of pros to factoring accounts receivable, including the following:

Speed: The speed of factoring accounts receivable as compared to obtaining a bank loan or line of credit is one of the most important benefits. When cash flow is stagnant in your business, growth becomes next to impossible. You might even struggle just to pay your usual bills, or make payroll. A conventional bank loan might take up to two months. However, a factoring company can give you access to your cash within 24 to 48 hours.

No Credit Checks: Unlike conventional lenders, don’t care about your credit. They care about the creditworthiness of your customers. So, if you’ve done your job correctly and are only working with customers that are low risk, you will have few problems finding a factoring firm to help foster continual cash flow in your business. Of course, if your customers are risky and have a history of slow payments or not making payments at all, you will have a difficult time finding a factoring firm.

No New Debt: Debt is part and parcel of doing business, but that doesn’t mean you should seek it out. Adding debt increases your company’s liability. Factoring accounts receivable does not create new debt. In fact, you’re just selling assets you already own in order to access the cash locked up inside unpaid invoices.

Essentially, it’s no different from selling unused office equipment or machinery to bolster cash flow. Because you’re not taking on any new debt, you gain liquidity without any additional liability. There’s no loan to be repaid, and no new creditor hounding you.

Access to Additional Services: In addition to ensuring steady cash flow to your company, you’ll find that quite a few factoring firms can offer additional services. For example, they can become your de facto billing department. This allows you to save on payroll if you’re considering hiring employees to handle this task, or time if you usually do all of your billing yourself.

That gives you more time to focus on actually running your business, rather than collecting payments. Specialised factoring firms can offer additional benefits. For instance, discount fuel cards are often provided as perks by factoring companies that serve trucking businesses.

Few Qualification Requirements: Unlike banks, factoring companies don’t really care what your financial situation looks like, or what mistakes you might have made in the past. As long as you have an invoice that meets their minimum requirements and your customer doesn’t represent a significant risk, you’re in the clear. This means that most companies out there will qualify to factor accounts receivable, unlike conventional bank loans, which come with very stringent requirements.

Taken together, these benefits show the real value of factoring accounts receivable. In fact, for many businesses, it provides the means to grow, even when clients are slow to pay, and allows them to avoid taking on new debt through bank loans or lines of credit. Of course, there are some cons that you’ll need to consider, as they may mean that this isn’t the right tool for your needs.

The Cons

While there are quite a few impressive benefits to factoring accounts receivable, there are some drawbacks that you’ll need to know. In most instances, these will not be deal breakers. However, they could mean that factoring is not a good fit for your particular company.

Fees and Charges: Factoring does come at a cost. At the minimum, you’ll pay a factoring fee. However, most factoring companies charge that fee by the month, so if your invoice is net 90, you’ll pay that fee three times. The fee also varies – it’s based on a percentage of the invoice total, and that percentage is different from one company to another.

Then there’s the potential for additional fees to be added in. These may or may not be explained upfront. You’ll need to go over your contract very closely. Factoring firms on the up and up should explain all their fees and charges, but not all companies do. Part of your due diligence should be to investigate the underlying costs and learn more about any potential hidden fees involved prior to choosing a factoring partner.

Your Profits: Understand that factoring an invoice means that you will not see 100% of the money your customer owes you. You’ll receive an advance on the amount due, and the remainder will be held in reserve. Once your customer pays, you’ll receive a percentage of the balance, but the rest will be taken as the factoring fee.

This can be bad news for businesses that run with very tight profit margins versus costs, so make sure you understand exactly how much factoring accounts receivable will cost you and how that will impact your profitability. If your profit margin is too narrow, you may be better off waiting for your customer to pay in the first place.

Customers Know about Factoring: When you choose to sell an invoice to a factoring company, they will inform your customer of the sale. This is necessary, as the factoring company will collect the amount due, and your customer will need to remit payment to the factoring company, rather than to your business. Some owners are uncomfortable with their customers knowing that they’ve sold their invoice, as it sometimes carries connotations of financial instability.

While that’s a misperception, it can impact your decision to factor accounts receivable in the first place. Some factoring companies do offer non-notification services, but they generally come at a higher cost. Only you can determine whether you’re comfortable with your customers being informed of the sale, and whether the additional cost of non-notification factoring is worth it.

Costs: We’ve touched on fees and charges, but we haven’t yet discussed actual cost. Understand that the ultimate cost of factoring accounts receivable tends to be more than what you’d ultimately pay over the life of a conventional loan. That makes factoring a valuable tool to use on a shorter timeframe, rather than as an ongoing, long-term solution to cash flow needs.

Of course, conventional loans cannot match the speed with which you’re able to get your money through factoring, or the additional benefits available through many factoring companies, so you’ll need to balance the higher costs against those perks to determine if this is a viable solution for you.

Contract Length: While some companies do factor accounts receivable on a one-off basis, others require that you sign a long-term contract. This will require that you factor all invoices from that customer moving forward. That may or may not be in your best interests. Ideally, you’ll know your requirements before taking advantage of factoring and choose a partner that offers the contract length and format that works best for you.

Tips for Choosing a Factoring Partner

If there’s one crucial consideration in factoring accounts receivable, it’s the partner you choose to work with. Not all factoring companies are cut from the same cloth. Some of them specialise in particular industries, while others work with pretty much any business, in any niche. Some companies offer spot factoring, which can allow you to sell one invoice at a time, or pick and choose the invoices that you sell.

Other companies require lengthy contracts and that you sell every invoice from that customer to the factoring company moving forward. There’s no one-size-fits-all solution here, so you need to choose your factoring partner with care. The right choice can ensure that you have positive cash flow in your business at all times, even if your clients are paying every 90 days. However, the wrong choice could leave you locked into a relationship that doesn’t offer the benefits that you need.

We can help ensure that you’re able to move forward, find the right factoring company, and see the benefits that you need. We invite you to take part in a free consultation with one of our factoring specialists. We can help you define your needs, the benefits that are of the most value to you, and then sort through the many options and find the ideal factoring company with which to partner.