How can factoring help growing companies?
Invoice factoring, also known as accounts receivable factoring, is an increasingly popular financial tool that allows companies to capitalize on the power of their outstanding invoices. Whenever a business extends terms to a customer they essentially offer them credit. Factoring enables the business to convert their invoices into immediate cash, allowing them to fund their daily operations. Accounts receivable from credit-worthy commercial clients are excellent collateral, especially to factors. Although most banks are less interested in accounts receivable – invoice factoring companies are focused on providing financing based upon them. This makes it an ideal financing vehicle for small and mid size businesses. Many prime contractors are finding the lack of access to capital restrictive.
How does factoring work?
Arguably the quickest access to financing, invoice factoring companies use invoices as the basis for making cash advances. The factoring company finances invoices and provides funds immediately, while they wait to get paid by the client’s customers. Perhaps, this transaction is best described with an example:
1. Assume that a client sells products/services to various customers. As soon as they provide their services, they issue invoices.
2. Having previously checked the account debtors (customers) creditworthiness, the customer is notified to remit payments directly to the factoring company.
3. The factor wires funds to the client making an advance which is the percentage of the total amount. The advance is usually 70% – 85% depending on certain variables. The remaining percentage is called the reserve, which is held until payment is received.
4. The factoring company waits to get paid by the client’s customers. Once paid, fees are deducted from the reserve and the balance is sent on to the client. Each time an invoice has been paid the transaction is retired.
The invoice factoring process can be repeated for every invoice issued, providing a flexible line of financing that grows with the business.
What issues affect the cost of factoring?
Typically the cost of invoice factoring is determined on these criteria:
1. The credit worthiness of the customers.
2. The length of time invoices take to get paid.
3. The monthly factored volume.
4. What industry is involved.
The cost, called a discount rate, can be as low as 1.5% or as high as 4% for a 30 day outstanding invoice, per transaction depending on these criteria.
How can I determine if invoice factoring will help my clients?
Generally speaking, invoice factoring will help your clients in need of capital if the business has reasonable profit margins or is growing too quickly. Mid size companies with 20% or more profit margins can usually do well with accounts receivable factoring. An additional advantage of invoice factoring is that it does not require owners to give up equity – enabling them to grow their company without diluting ownership or showing any long term liability on the balance sheet.