How To Tell If Factoring Is Right For Your Business
by Carrie Hinkel on October 15th, 2007
Factoring is the selling of a company’s outstanding accounts receivables at a discount to a third-party factoring company.
How factoring works
Once the amount of money expected to be received from customers is calculated, the right to collect that money is then transferred to the factoring company. Your company will then receive a portion (typically 60%-80%) of that money upfront, with the rest waiting in reserve until the actual amount collected is determined by the factoring company. After the money has been collected by the factoring company, the reserved money is then released to you, minus the factoring company’s discount fee (usually 1%-5%, depending on the age of the receivables).
Factoring is an alternate source of funding worth considering for a small business, however it has both positive and negative characteristics that need to first be considered.
What the factoring company will need from your company
Before a factoring company will agree to collect on your receivables, you will need to prove to them that your receivables are indeed legitimate claims. For most companies this should be fairly easy, as long as you have kept documentation of sales, orders and other business transactions. You’ll need to provide a detailed list of the receivables, with customer contact information for each. You’ll also need an actual invoice for each receivable to be collected.
The benefits of factoring
Allows a company access to immediate cash: For a small business, an influx of cash can help to purchase more inventory, pay off debt, purchase advertising or other business-related expenses.
Eliminates debt: Since you are essentially borrowing from your own resources, you won’t be making payments; and since it’s not a loan, it doesn’t show up on your credit report.
Credit rating is not an issue: The factoring company is more concerned with your customer’s ability to pay, rather than yours. So, for those unable to qualify for a traditional bank loan, factoring may be a good alternative.
You don’t have to handle collections: Since the factoring company has taken over the responsibilities of receiving payments, you can eliminate the administrative tasks of collecting and spend your time more effectively.
Not a long-term commitment: You can choose to factor out as many invoices as you want. Factoring can be a great temporary solution during peak operating times.
The flaws of factoring
Expensive fees: A fee of 1 to 5% to the factoring company may not sound like much, but remember, that rate is only for a period of thirty to sixty days. Compared to a traditional bank loan, the annual rate with factoring is much higher.
A third-party company is contacting your customers: Depending on how the factoring company communicates, this can have a negative effect on business if your customers are not treated properly. When looking at prospective factoring companies to work with, this is definitely something you’ll want to check on.
Using a factoring company may be a good financing alternative for fast-growing small businesses. Be sure to do your homework and research several companies (along with checking references) before you make your final decision on a factoring company.