Selling Accounts Receivable Can Improve Cash Flow
We all know that banks do not provide a friendly credit environment for small businesses. If they offer any money, it usually isn’t enough. The absence of lending often leads slow grow your company due to a lack of funds. However, there is a type of financing that is significantly increasing in popularity in our industry. It’s called factoring. Factoring is a type of funding that concentrates on your customer’s ability to pay, not yours.
Factoring is the sale of your accounts receivables (invoices) to a funding source at a discount from the face value in return for immediate cash. The funding source is a factoring company.
The process typically works like this: You provide products and services to your customer and issue an invoice. Without factoring, you wait 30-60 days for payment. With factoring, the factor immediately purchases the invoice and advances an initial payment of approximately 90% of the invoiced amount. In most cases, you’ll have funds in your account within 24 hours. When your customer pays the invoice (payment is made directly to the factor), you’ll receive the remaining balance less the factor’s fee.
Factoring and purchase order financing are well-established forms of business financing that produce immediate cash payments at the time of shipment, delivery and invoicing a customer. In its basic form, factoring has been used by American business since colonial times, and its origins date back even further, thousands of years to the early days of commerce.
American consumers take part in a common form of factoring every time they use a credit card. There are 1.8 billion credit cards in circulation, 3.75 each for every American cardholder. In 1970, the average balance on individual cards was $649, increasing in 1986 to $1,472, and today it is $15,950. Millions of times throughout the day, every business that offers customers charge privileges using credit cards is the direct beneficiary of factoring. American retail business depends on the factoring system, and without it the national economy would be severely handicapped.
In this familiar transaction, the issuing bank or card company is the factor – using Visa, MasterCard or other systems. Advancing the seller of merchandise or service immediate cash after your purchase, long before you pay. Because the seller gets cash up front without having to wait for your payment, his money is not tied up in receivables. For the double privilege of making credit available to customers and getting immediate payment, the business is willing to pay a discount to the issuing bank or credit card company – typically 2-4% of the purchase price. Thus, for every $100 of merchandise you buy with a credit card, the seller gets $96 or $98 in immediate cash.
Factoring accomplishes the same for commercial or business-to-business transactions. When you extend credit to a customer, you are essentially becoming that customer’s part-time banker. For the period credit is extended to Customer Smith – 30 or 60 days – you become his lender, and he your borrower. For the length of time credit is extended, you lose the value of the tied-up money because you can only anticipate payment. If Mr. Smith had paid cash, you could have invested that money immediately, earning interest on it rather than having to wait. When Mr. Smith pays late, your cost increases further still.
There is no “free lunch” in business, someone has to pay the costs of your extension of credit. Either you pay by reduced profits or your other customers are forced to pay higher prices. In a marginal company, excessive credit extension and late customer receivables can spell disaster.