It is an understatement to suggest that obtaining traditional bank financing or increasing current loan obligations is difficult for a small business owner in today’s economic situation. In recent years, banks have tightened their credit requirements and will continue to do so for the foreseeable future.
Credit lines are being cut, and funding to support expansion and new business prospects and for businesses with no capital is scarce unless you’re willing to give up equity, which is still a challenging proposition. Even companies with long-standing relationships with their banks are having difficulty renewing their lending facilities on an annual basis.
Where can today’s small company owner get the funds he or she needs to keep the firm running, pursue new development possibilities as they arise, pay vendors on time, and meet weekly pay stubs? Accounts receivable financing is one option.
Accounts Receivable Financing
Factoring, or accounts receivable finance, is a method of funding a business’s working capital swings and cash-flow demands. Factoring has been around for decades, while being largely unknown in today’s mainstream financial sector. Since the pre-1400s, it has played an essential role in business.
Factoring, also known as accounts receivable financing, A/R funding, or growth capital, is a method of using a company’s accounts receivables to fund its cash-flow needs. Clients are given funding based on their accounts receivable balances and today’s invoices, even though the invoices may not be paid for 45 to 90 days or longer.
Assume a remodeling company has $50,000 in receivables that are due in less than 90 days. Depending on the business and the underlying credit evaluation, most factors (privately held finance organizations) provide an advance rate of 75 to 85 percent of the invoice amount. In this case, the renovation company might borrow up to $42,500, or 85 percent of its $50,000 in receivables.
Assume that the invoices are paid within 60 days. To receive payment, the factor will have set up a lockbox account that it controls. The $42,500 advance from 60 days ago is repaid, leaving a $7,500 balance owed to the remodeling company, less the factoring fees. Factoring fees range from 2 to 4% each month, depending on the factor’s assessment of the overall risk. Rather to an overarching credit line as banks offer, each factoring transaction is invoice specific.
Instead of waiting 60 days for invoices to be paid, the remodeling company was able to borrow $42,500 up front. This enables you to take advantage of vendor discounts, which can help you save money on your factoring cost. For instance, if a vendor gives a 3% discount if payment is made within 10 days, the savings can be used to offset the cost of modifying the bus.
If a vendor offers a 3% discount if payment is made within 10 days, the discount can be used to offset the remodeling company’s factoring cost if it is 3%.
Factoring also provides quick cash flow and working capital, allowing you to fulfill payroll and purchase materials for the next task without having to call consumers weekly to collect payments. The most crucial benefit of factoring is that it allows business owners to concentrate on running their companies.
Although banks are concerned with profitability, balance-sheet leverage, equity, and financial ratios, the credit quality of a company’s customers is the primary consideration. Customers (debtors) are the most important factor in determining whether a factor will fund a company. Debtors also have a say in how much money is given to them.
Receivables must also be verifiable, which means that it is vital to verify that the goods have been delivered or that the services have been completed.
Factoring enables a company to borrow more money against its present receivables by offering higher advance rates and more cash flow, as well as less reporting requirements than banks.
The following information will be required for the majority of factors:
- Accounts receivables are now aging.
- Financial statement for the current month.
- Accounts payable are currently past due.
- The most current tax return for your firm.
- A standard application.
The factor will order credit-agency reports about a firm and the debtors it wishes to factor after reviewing this information. The debtors must sign the application, authorizing the factor to access credit information. Individual credit reports of the business’s majority owners will also be examined by the factor. The factor will then conduct a Uniform Commercial Code search to ensure that the business’s receivables have not been pledged as collateral to any other lender.
The factor will assess if a company qualifies for accounts receivable finance based on this review. A decision may usually be made in two to five business days after the appropriate information is received, and funding can happen in ten business days. If a company has solid consumers who pay in less than 120 days and the owner’s credit score is above average, the company is usually accepted.
The factor frequently serves as a company’s internal credit and collections department. On past-due invoices, the factor will conduct collection calls and assist with the business owner to recover payment from clients as soon as feasible.
Take into account factoring
For numerous reasons, factoring is more expensive than bank finance. To begin with, the majority of the elements are privately held small enterprises that receive finance from banks and private investors. As a result, the factor’s cost of financing is substantially greater than that of banks, which borrow at nominal rates from the Federal Reserve. Second, because the risk is larger, businesses who employ factoring must pay for it.
It’s vital to remember that factoring is not the same as a loan, which is a debt that accrues interest on a balance sheet. Factoring is a cash advance on a company’s invoices that puts money in the company’s bank account without putting the company under any obligation to repay it because the company did not borrow money; instead, it sold an asset.
Although there are increased costs associated with factoring, the benefits delivered might far outweigh those expenditures. Even if the business is going through a down cycle or losing money for a period of time, knowing that a funding source is there today and tomorrow might bring much-needed respite.
Factors will continue to fund enterprises through down periods and boom cycles as long as they are doing legitimate work and providing verified goods or services. For many small business owners, this might mean everything.