Need Cash Fast? Consider Factoring

From time to time, nearly every business experiences a cash shortfall.

Why do such shortfalls happen? It typically goes back to the cash conversion cycle. Most businesses pay workers either weekly or biweekly.

They also try to pay suppliers and vendors in accordance with the negotiated payment terms (typically net 30 days). Some might even pay creditors early to take advantage of early payment discounts. These payments, along with any loan payments, drain cash from the company's bank account.

Meanwhile, it takes time for the business to invoice customers and collect accounts receivable. The end result is often a cash crunch -- especially during seasonal peaks when cash outflows temporarily outpace cash inflows.

Factoring to the Rescue

Although delaying payments isn't always possible or advisable, business owners might be able to generate much-needed cash by selling the rights to collect their accounts receivables to a third party. Selling accounts receivable balances, also known as "factoring," immediately brings in cash in exchange for fees paid to the factoring firm.

Here's an example of how it typically works:

Your customer owes $6,700.
You sell the right to collect the balance to a factoring firm, commonly known as a "factor," for 80% of the face value or $5,360 ($6,700 X 80%). The factoring company sends you that amount, known as "the advance."
The difference between the amount the customer owes and the advance ($1,340) is known as a "reserve."
The factoring firm charges a fee of 1% for each month that the reserve remains outstanding.
The customer pays the invoice after 30 days.
The factor retains 1% of the reserve ($13.40) and sends you the remaining balance ($1,326.60), known as the "rebate."
In addition to charging a discount fee, factors typically deduct additional fees from the rebate. These can include bank fees, cancellation fees, due diligence fees and an initial application fee.

Research Factors

Think factoring might work for your business? Here are some important questions to ask before you hand over your receivables to a factor:

Should you enter into a recourse or nonrecourse factoring arrangement? Signing a recourse factoring agreement means that your company agrees to buy back receivables that the factor doesn't collect.

With a nonrecourse factoring arrangement, the risk of a customer defaulting generally transfers to the factor and, in most circumstances, doesn't come back to your business. However, there could be exceptions where the factor would require your company to buy back the receivable.

Does the factor understand your industry? Factors that specialize in certain sectors -- such as trucking, real estate or construction -- are likely to have a strong grasp on industry terminology and understand the challenges of collecting from customers. Remember, factors hold back a reserve and charge a fee that increases the longer a balance remains uncollected. The quicker a customer pays, the lower the fees deducted and the greater rebate you receive.

How quickly will the factor advance funds? When cash is tight, timing is crucial. Before factoring your first receivable, establish how long it typically takes the factor to issue an advance. In addition, gain a detailed understanding of the process your company must follow to submit an account. Most factors provide small businesses with access to a dedicated online portal to submit new requests quickly.

What advance rate and fees does the factor require? Factors generate income from two sources: the discount fee and miscellaneous charges related to creating the factoring relationship as well as maintaining and collecting on the factored accounts. Advances range from 70% to 98%, depending on the business and the solvency of its customers.

How financially stable is the factor? The success of a factor depends on its ability to provide advances and pay rebates in a timely manner. Ask each prospective factor for an overview of their funding sources.

In addition, ask each factor for a detailed breakdown of its respective fees. Create a simple spreadsheet for each firm's fee structure. Be sure to inquire about whether a factor requires a monthly minimum transaction. Factoring less than the monthly minimum generates additional fees to maintain the financing relationship. Also search for online reviews and ratings for each firm. Pay close attention to reports regarding delays, excessive fees and an inability to collect on reserves. These all point to operational challenges and reasons to avoid that firm.

Pick a Winner

Depending on your location, multiple factors might respond when you start looking for service. Take the time to evaluate which one best suits your needs. And remember, while factoring your accounts receivables can provide access to cash, it's just one of many ways your business can improve its cash flow. Consult your CPA for help devising the optimal cash-flow strategy for your situation.