Utilizing Factoring to Increase Cash Flow

By: Nate Hananger

When a business sells a product or service to a consumer, it's a cash-and-carry basis. They pay and then receive what they purchased along with a receipt. However, when a business sells a product or service to another business this is known as a commercial transaction. Often times invoices (a.k.a. accounts receivables) are used in such transactions, leaving a window of usually 30-60 days for the debt to be paid.

Most small to medium-sized businesses recognize the importance of cash flow, which is exactly why factoring is of use to them.

Allow me to give you an example to better explain the process of selling your invoices. Let's say Joe's Printing provided a client, a local magazine company, with $200,000 worth of products. Joe's Printing then sends the magazine company an invoice for that amount with a due date in 30 days.

Unfortunately, not all businesses pay invoices on time. Even if the magazine company intends to, perhaps Joe's Printing needs to cover rent, pay employees and deal with other business-related expenses immediately.

By factoring this invoice, Joe's Printing could cover those costs on time and still generate profit. So the company contacts a factoring broker, who then contacts a funding source who purchases invoices - known as the factor. The factor then offers Joe's Printing $190,000 to purchase the $200,000 invoice - 95 cents on the dollar.

Typically the factor (the investor) will send the company selling the invoice roughly 75% of the agreed purchase price as a cash advance - in this case that would be $142,500. Then, once the invoice has been paid the rest is paid to Joe's Printing - $47,500. This percentage may vary under different circumstances.

There are funding sources (factors) who offer recourse factoring and some who offer non-recourse factoring. Recourse factoring, designed to eliminate any risk on the investor's end, allows the factor to rescind the deal after the invoices have been sold in the event the unpaid debt isn't paid by the owing customer(s). In this event the business who sold their invoices may end up reimbursing the factor. So the invoices may be with the factor, but the risk stays with the company.

Non-recourse factoring is far more beneficial for the business owners who wish to factor their invoices. The risk of the debtor failing to pay the debt is assumed by the factor, rather than the business. No refund options are available, with the exception of defective goods or services. This option allows the business which sold the invoices to keep the funds received for them regardless of default payments.

Often times people confuse factoring with loans. This is a method of financing, but it's not a lending service. It's a transaction where invoices are sold, at a slight discount, to a third party who advances the business the much needed funds. If you owned a struggling business, would you knock 5% off of your invoices in exchange for immediate cash?

Banks and lending institutions simply cannot compete with factoring. Buying invoices would decrease a lender's available capital, limiting how much they could lend. And even if a loan secured by the invoices was negotiated, the borrower would be lucky to receive 50 percent of the owed balance of the invoices.

Factors focus on the creditworthiness of the clients who owe money on the invoices, rather than the strength, credit and financial stability of the business holding the invoices like banks do. Combine all of the reasons already stated with the sky-high interest rates one would face when attempting to obtain a loan against accounts receivables and you can see why factoring is most definitely a smarter decision.

Businesses benefit from factoring because it allows them to match the speed of growth from improving cash flow, pay employees on time, cover taxes, decrease overhead costs and providing ample funding for debt restructuring, acquisitions and expansion.

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