Can invoice factoring be the solution to the credit crunch companies are facing today? It might just be! After all, factoring isn’t a loan and won’t appear as a liability on the company’s balance sheet. This makes it a clean transaction and one of the reasons why many businesses have come to rely upon to manage their daily expenses. With the economy mired in a long recession and customers taking longer to pay invoices, every company is left struggling to find a solution.
Unfortunately, as the situation has deteriorated, banks have been less than accommodating by raising interest rates and imposing tighter lending restrictions. It’s a vicious circle where late payments mean tighter credit. Therefore, if invoice factoring is indeed the solution, what must companies do to make sure they use it properly?
The Factoring Process
In order to understand the benefits of invoice factoring, companies must be willing to do away with certain myths or untruths. First, factoring isn’t a loan. Therefore, it doesn’t involve an assessment of the company’s credit history, a review of its financial statements and is in no way tied into its financial performance. Second, factoring isn’t new. It’s a practice whose history goes back thousands of years. Third, factoring isn’t expensive.
At one time it may have indeed been a risky and expensive endeavor, but today’s factoring companies offer extremely competitive fees when compared to the interest rates charged on bank loans and business credit lines. In fact, these fees amount to pennies on the dollar. However, does this mean that factoring is the “end-all be-all” solution? No. Like any financing option, it has both a good and bad side. However, to better understand the bad means to do away with those falsehoods of factoring. These points are summarized below.
- Factoring isn’t a loan (doesn’t appear as liability on balance sheet)
- Factoring isn’t new (long history)
- Factoring isn’t expensive (may have been at one time, but no more)
How Does Factoring Work?
Factoring is an Asset-Based financing solution. It works by allowing companies to sell their invoices (assets) for immediate cash. Payment varies according to the age of the invoice and the payment habits of the customer who owes on the invoice. Early invoices, coupled with good customer payment history, means the company will secure a higher initial payout. In return, the factoring company collects on the invoice directly from the customer.
Once they’ve successfully done that, they return the difference from what was originally collected and then charge a fee for their services. In essence, it’s as if the company is selling its receivables. Companies basically sell their customer’s invoice and the right to collect on that invoice, to the financing company.
Factoring Defeats the Daily Cost of Money
Most companies are unsure of just how costly the daily cost of money is. To understand the daily cost of money, think of the company’s cost to purchase inventory and the costs of financing payroll and operations. When a company sells product, it is essentially paying a daily interest rate every day its customers don’t pay that invoice. For instance, most companies finance their inventory with business credit lines. These credit lines have a yearly interest rate that can be divided into a daily interest rate.
When companies sell inventory, they continue to pay interest on that inventory until their customer pays the invoice. The longer it takes the customer to pay the invoice, the more expensive it becomes. Factoring defeats the daily cost of money by empowering the company to secure cash sooner than waiting for their customers to pay.
The table above and the video are from the post: Sample Receivable Factoring Excel Sheet: Effective Rates & Interest Rates
What to Watch Out for When Using Factoring
Again, like any financing option, there is both good and bad with factoring. First, your company is essentially outsourcing its receivables collection. Someone other than your company will be pursuing your customers for payment. Are you comfortable with that happening? Second, companies often use factoring across the board on all receivables. Ideally, I would suggest using factoring with those customer accounts that aren’t your company’s highest priorities.
If the factoring company has demonstrated professionalism in handling collections, then you could gradually progress to using their service across the board. Finally, companies must measure the impact of the cost of money on their overall gross profit. For instance, if the company’s gross profit margins are razor thin, then it may or may not be beneficial to use factoring. Other options like prepayment may be best to defeat the daily cost of money.
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