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In the world of small business where cash is king, a business’ cash flow is a key indicator of their financial health. For businesses that are facing cash flow issues or problems with slow accounts receivable, there is an alternative solution for finding cash in a pinch that doesn’t involve taking on conventional debt through credit: factoring.
As more people learn about factoring, its popularity as an alternative to traditional small business loans increases. Factoring helps many businesses smooth out their cash flow issues and receive cash quickly, all without the lengthy conventional business loan application process.
What is Factoring?
Factoring is when a business sells their accounts receivable or invoices to a third party, known as a factoring company. The invoices are sold to the factoring company at a discount, but the factoring company gives the business immediate funds or cash for the invoices.
Factoring can provide a win-win situation for both parties involved. The factoring company makes their profit through the discounted invoices they purchase and the business that sold their invoices receive fast cash without the hassle of having to wait for invoice payments to roll in.
How Does it Work?
Factoring usually has two parts or installments- the advance and the rebate. As soon as the invoice is received, a factoring company will pay you the advance in exchange for selling the invoice. Advance rates vary by industry, but roughly 80% of the invoice’s value is a typical advance rate.
The second installment is known as the rebate. After your customer pays their invoice in full, the factoring company pays you the remaining 20% or whatever amount not covered in the original advance, minus their discount rates and fees.
How Does the Factoring Company Make Money?
Two elements determine how much money a factoring company will make from your invoices. Factoring companies charge a predetermined discount, or factor, rate on the value of each invoice. Discount rates vary depending on the industry you’re in, and the creditworthiness of both you and your customers. The rates can vary from just a percentage point to over six percent of the invoice value. The discount rate is charged at regular increments as required by your contract until your customer pays in full.
A factoring company might also charge fees other than just the discount rate. Fees commonly charged by factoring companies might include origination fees, ACH transaction or wire fees, overdue fees, interest charges, or unused line fees. When working with a factoring company, it’s always important to read your contract carefully and ask about any additional fees beyond just the discount rate.
Factoring companies make the majority of their profit on the discount rate that is usually charged by the month, but sometimes by the day or week. For this reason, factoring works best for businesses that have customers who pay on-time and usually within net 90 days. The longer it takes a factoring company to collect on your invoice, the more expensive the service will become.
We know that’s a lot of moving parts! Here’s a simplified example for you:
You factor a $100,000 invoice that has an 80% advance rate, 20% rebate, and a discount rate of 2% per month. With your first installment, you would receive $80,000 or 80% of your invoice. If your customer pays you in 30 days, the factoring company will keep $2,000 from the remaining $20,000 rebate, leaving you with an $18,000 rebate. Altogether, you collect $98,000 on your $100,000 invoice, giving 2% to the factoring company.
Advantages of Factoring
- Factoring is a good alternative for a business that would have trouble qualifying for a traditional loan because of limited or no credit history.
- Qualifying businesses receive almost instant cash from their factoring companies to help smooth out their cash flow issues, without taking on new debt.
- Some customers might pay their invoices more quickly because they know they are paying the factoring company instead of you, with whom they are more familiar.
- Factoring companies can help you determine the creditworthiness of your potential customers to avoid the financial headache of customers who don’t have the ability to pay on time or at all.
Disadvantages of Factoring
- Instant reduction in your profits on each order you fulfill. This is the price you pay to receive your cash quickly.
- The factoring company will need to notify your customer and make contact with them. Although many industries are used to the practice of factoring, for those industries that are not, it’s an additional step for your customer. Some customers might prefer to deal directly with you.
- If your company has an existing tax lien or extensive legal problems, you will not qualify for factoring.
- Some factoring companies charge additional fees on top of their discount rates. Read all the fine print before you sign a contract with a factoring company.
- You might enter into a long-term contract with a factoring company when your cash flow issue is only a short-term or seasonal problem.
These are just a sampling of the advantage and disadvantages of working with a factoring company. Although it’s not right for all business or situations, it is an alternative route to quickly smooth out cash flow bumps with a quick and easy injection of cash. As always, do your research before committing to any sort of financial decision to ensure you’re doing the best thing for you and your business!
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