Accounts receivable factoring offers many businesses an excellent source of much needed cash right when they most need it. This type of factoring provides a solution for cash flow challenges and is available when traditional financing is often scarce. While not every business qualifies for this service, many business owners and managers depend on accounts receivable factoring as the major financial tool that solves cash flow problems that could otherwise bring business to its knees.
An accounts receivable factoring transaction involves a factoring company’s purchase of a client’s accounts receivable in exchange for a cash advance. The company that purchases the receivables is called a factor. The incentive that the factor company has to purchase receivables is the profit they earn since they purchase at a discount. The difference between the receivables balance and what the factor pays for that asset is the profit earned.
Why Factoring Works
Factoring works to satisfy a need that many companies have for dependable and consistent cash flow. One major point that makes factoring different from lending is that the cash advance is not a loan that needs to be repaid. Another reason factoring works well is because everybody wins. Companies that might not be credit worthy in the eyes of the banking community can obtain cash when they need it.
Factors purchase receivables based on the value of the asset, or the credit-worthiness of the specific receivable. In other words, if a small business is owed money by a larger company that is considered credit-worthy, the factor does not care whether the small business is the perfect borrower on paper or not. For this reason, factoring is the perfect choice for up and coming companies that would be unable to qualify for a commercial loan. For instance, criteria such as length of time in business and having a healthy balance sheet do not matter.
One of the main reasons companies decide to utilize factoring is to fund sales growth. While most executives cite growth as a major objective, growth is not easy to achieve with limited funds. Factoring supplies the funds needed to take the next step up in business to fuel the additional human and material resources required for growth.
Another reason that factoring works is because factoring executives enjoy a lot more latitude than lending professionals. While it can take lenders months to approve a loan, factoring companies can often deliver in as few as ten days when necessary. Factors are much more likely to modify guidelines to accommodate good clients.
Conserving collateral also adds to the list of positive reasons to utilize factoring instead of turning to a loan option. Factors usually limit the collateral pledged to accounts receivable only as compared to bankers who require borrowers to pledge all of their assets in many situations. By doing this, companies can preserve their balance sheet for future growth and a stronger financial position for other challenges.
Qualifying for a Factoring Advance
Unlike the lengthy loan process that often requires audited financial statements, significant collateral holdings, and favorable debt to equity ratios for consideration, factoring businesses require much less. Typical qualifications include a portfolio of receivables owed by debtors believed to be a low credit risk. Factoring companies evaluate whether they believe a prospective client can afford the costs associated with factoring and still remain profitable.
One of the reasons many companies shy away from getting involved with factoring relates to the perceived cost. For example, the annual percentage rate (APR) of a 30-day discount rate used over a 30-day collection period is 37 percent. Compared to conventional bank financing, that figure sounds extremely high. When business executives consider the availability of funds, flexibility and timeliness offered by factors as compared to banks, they often decide that the perceived high interest rate is not that significant when considering the many advantages.
Whether times are good or bad economically, companies all need cash to survive. Accounts receivable financing offers companies one more financial tool to add to their corporate bag of tricks to meet unexpected challenges. For companies interested in improving cash flow or preserving their balance sheet, accounts receivable factoring is something to evaluate as a financial management strategy.