Accounts Receivable Financing Pros and Cons
Are you a small business owner thinking about using accounts receivable funding for your business? As a small business owner, you likely know first-hand the struggle of acquiring capital to finance the growth of your business or meet those cash flow shortages. There may come a time that traditional small business financing such as loans and credit will be limited or not within reach. At times like these, some business owners will turn to accounts receivable financing. Is accounts receivable financing right for your business?
It is not without reason that accounts receivable financing has been consistently gaining in popularity. The benefits of this type of financing for small businesses are sometimes too good to resist. Is your company ready to join the increasing number of companies resorting to accounts receivable financing to meet the immediate requirement of funds for the further growth of their businesses? This article will help you determine the answer.
First of all, to understand if this type of financing is right for your business, you will need to spend some time to fully understand what it is. Factoring is one of the oldest forms of commercial finance. Accounts receivable financing is a process that involves the selling of outstanding invoices or receivable at a discount to a specialized finance or factoring company (usually called “the factor”) that will assume the risk on the receivables and in return will provide a quick influx of cash into your business.
The amount of value assigned to the account will depend on the “age” of a receivable. An invoice that is current will pay more than one that is a month or two old. Accounts receivable that are more than 90 days old are typically not financed. Why not? These invoices present too high of a risk. They are already “late” and may not be paid. Accounts receivable financing has also been referred to as accounts receivable factoring or accounts receivable funding.
To better understand factoring, let’s put some numbers in an example. Suppose for a moment that your small business has $100,000 in receivables. A factor will advance funds to you at a certain percentage of the total amount. This amount often ranging from 75 to 80 percent is based on a variety of factors including the age of a receivable as discussed earlier and the quality of the receivables. If you have customers like Costco or Walmart, then the percentage will be much higher. Once the receivables are paid off, you will get the difference between the face amount and the reserve.
While accounts receivable funding may be a new concept to you, it has been a viable funding source for a long time. It has both pros and cons, and once you clearly understand what it is, it’s time to think about the good and bad for your business. These are still pretty tough economic times for many small and medium sized businesses. Just having the option of accounts receivable funding may be music to your ears, especially when traditional lenders have been feeding you a chorus of no’s. This type of financing can seem like a very easy and logical way to finance operations, particularly in an environment where financing is difficult to secure. And when your back is against the wall and there are few alternatives available, it may be an appropriate choice for some.
Pros of Accounts Receivable Financing
First let’s look at the pros, sometimes it’s best to look at the bright side! There are both pros and cons for every business financing option, and accounts receivable funding is no exception. It is important to weigh out all of your funding options before you make your decision and evaluate any and all flaws. Some businesses may benefit more than others by choosing to use a factor while others may benefit by seeking help from alternative funding options. There are indeed many benefits of this type of financing for businesses of all sizes in a variety of financial situations.
Your company may need immediate cash for a variety of reasons such as buying raw materials, renovations, or payroll. Of course, cash usually comes from clients and customers who pay for your goods and services. However, if these payments are delayed, your business needs to look for other ways to cover these expenses. So if raising cash is an immediate need and you are having a tough time borrowing through banks or raising funds by issuing debt or equity, accounts receivable factoring can be an effective alternative resource. Believe it or not, it is possible that you can receive cash in about five to 10 days. In some cases, it could be within one to two days.
Free Up Working Capital
Like most businesses, your business likely has the majority of its capital tied up in your inventory. Accounts receivable funding can quickly free up some working capital, so you can use it to grow your business. That great deal on inventory won’t pass you by if you have the cash ready and waiting. You can use the instant cash to generate growth by hiring another salesperson who will bring in more business. Or buying an advertisement that will reach new customers. Or buying a piece of equipment that will accelerate production.
Accounts receivable factoring can save you time and effort that would otherwise be spent on collecting money due from customers. Since most factoring arrangements will include the process of obtaining the money from customers, it’s one less thing you will have to worry about. Outsourcing your accounts receivable management to another company frees up your resources to focus on other more productive (and lucrative) activities such as selling. The factor will take care of getting the money they definitely want to get paid. And you can use the time and money normally spent on collections and redirect it to making money and building your business! Sales, marketing, and client development can all use your excess time and money.
No Collateral Required
Factoring is a type of unsecured financing. It won’t require collateral from your personal or business assets. You really don’t want to put up your house, car, inventory, or place of business up as collateral for a loan. Those are the things that matter most to you, and you really don’t want to jeopardize having them taken away. While most traditional lending options will require some sort of collateral from you, accounts receivable funding will not. So keep the things that matter most, and get your much needed infusion of cash from a funding source that doesn’t require them!
The last thing that you want to give up is a part of your business. You have worked hard to start it, run it, and keep it solvent your way. Often small businesses and start-ups have to rely heavily on outside investors in order to keep running and growing. While this might seem like a good idea, it does force you to give up a percentage of your company each time you go back for more funding. With accounts receivable factoring, though, you will retain sole control of your company while still getting the capital you need to operate.
Cons of Accounts Receivable Financing
While there are a large number of benefits to factoring your accounts receivable, there are just as many potential drawbacks to using this method to finance your small business. Make sure that you educate yourself about the cons of accounts receivable financing before committing your business to this type of financing. Just knowing what could go wrong will help you make the right choice.
There is a certain “stigma” that goes along with factoring. The stigma is not that it is fair or just; instead, factoring is a viable and legal financing option. Unfortunately, many people think it’s a business’s last resort before failure. One of the most common thing small business owners don’t know about factoring is that their customers are notified when a factor takes the receivables over. The customers will no longer be paying you, but rather paying the factoring company. And it may unjustly make them think that you are having cash flow problems.
Loss of Control
While factoring will allow you to keep your interest share in your business, you may lose some control of certain processes. Unfortunately, what happens once you accept cash for your receivables is that you do give up a measure of control. As an example, the factoring company could deny your ability to do business with a particular customer or group of customers because of a poor credit history or rating.
As the old adage says, nothing in life is free. And as a savvy business owner, you know that financing of any type is never free! While it may be necessary to have immediate access to cash, obtaining cash using factoring may come at higher price than loans. Factoring companies usually keep between one and four percent of a receivable as their fee. Additionally, they can (and will) charge interest on the cash advance, typically at least the prime rate plus a percentage or two. While month to month it may not seem like all that much, it all can add up to more than 30% in annual interest.
If you decide that accounts receivable funding is for you, you will enter into a contract with a factor. Unfortunately, the length of your contract may not be as short as you would like. Some of the agreements can be quite lengthy—up to two or three years in some cases—and that’s not always the best thing for businesses. But the market has been changing and shorter contracts are now becoming available and acceptable. Make sure you negotiate the contract length with your factor!
Rate is Based on Your Clients
Like any business, you have your share of good and bad clients. Not all of your clients can be like Walmart. If your business has an unfortunate number of slow-paying clients or has some clients with less than stellar credit, keep in mind that these factors can affect the discount rate that you pay to the factoring company. If your clients are determined to be unreliable or do not meet a factor’s standards, you may also receive a lower percentage up front. It may even cause you and your business to be ineligible for funding through this method.
Factors are Not Collection Agencies
Remember that factors do not act as collection agencies, so if a client does not pay their outstanding balance by a predetermined date or they fail to pay altogether, this will likely increase the total cost you owe a factor in addition to adding to your current workload. Before you consider factoring as an option for a cash advance, make sure you are aware of your clients’ payment history. Although factoring services can be beneficial for various businesses, it may not be the best decision for you if you cannot rely on your clients.
All companies—big and small—need access to credit in order to support their inventory, meet payroll and pay their day to day operating expenses. And all companies will have times where they need money quickly. Unfortunately, given the current economic downturn, credit has become so tight that many small companies find that have but few financing options remaining. However, accounts receivable funding is one option that has allowed companies to weather this current economic storm. Educating yourself about the pros and cons of this type of financing will help you decide whether this is the right choice for your business to pursue.