Almost all businesses face a tradeoff between a strict credit policy and increasing sales. On the one hand the company wants to have a steady cash flow and so it may perform credit checks and require that all receivables be paid within a very short time. This helps the accounts receivable turnover time and overall company cash flow, but it also scares away certain customers.
It’s no secret that loosening the credit terms allows a company to have more sales. That’s why you see a lot of companies saying they will finance anybody or they will allow the customer up to a year before they have to make any payments. However, companies with this type of policy soon find that a lot of customers never end up paying. They also find that their cash flow is very unsteady and they go through times when they barely have enough cash to pay employees.
Factoring receivables may be a partial solution to this tradeoff. With account receivable factoring the company “sells” its receivables to a third party, known as a factor. The factor gives the company anywhere from 60-90% of the invoice up front. Then once the factor collects the invoice they pay the remaining balance to the factor with a charge of course. More on this below.
How does the Factor Decide on How Much to Give up Front?
The factor looks at the accounts receivable aging, past collection history, and the company’s industry when deciding how much to pay the company up front for its receivables. Basically, they want to know if they are going to be able to collect these invoices that are being sold to them. If they determine that it is a low likelihood that they will collect, they may not pay for the receivables at all. If they think they have an average chance of collecting them, then they will pay around the 60% range. If it’s a sure thing, then they will pay closer to 90% up front.
There isn’t a whole lot you can do as a company to persuade the factor to pay you more up front. However, it helps to keep your books, especially your accounts receivable, looking orderly. Show the factor that you keep good track of your customers and have a high percentage of customers that pay on time. It helps to put your best face forward when factoring receivables.
How Much Does Receivable Factoring Cost?
After the customer pays the invoice, your organization will receive the rest of the money minus a charge. How much this charge is depends on how long the invoices have been outstanding and on the factoring company you are working for. Most of the factoring companies charge between .5% to 2% per 30 days.
This can be a great deal for some companies and a bad one for others. If you’re in the 2% range and you factor receivables all year then that is around 24% financing. That is quite a lot for something backed with an asset. However, it still might not be a bad deal if you really need the cash and can’t get the cash cheaper.
If a company is in the .5% range, then this can be quite a good deal. Not only are they getting a pretty low annual rate (around 6%), they are also getting someone else to collect their invoices for them. This can free up time and resources to put in other areas.
Note that some arrangements with factors provide for them to deal with collections. Another arrangement, known as confidential factoring of receivables, makes it so your customers don’t know of the arrangement you have with the factor. In this case your company will likely be the one that collects the invoices.
Having a factor collect invoices for you can be nice because they are experts at it and it frees up time and resources as mentioned above. However, they may not treat your customers how you would like them to and this may have the hidden cost of scaring away repeat customers. If this is a concern for you, then find a factoring accounts receivables arrangement where your company is still in charge of collections.
In summary factoring receivables may be a tool that can help your company balance loose credit with consistent cash flow. A company that handles invoice factoring pays for a portion of accounts receivables up front and then remits the rest of the payment with a charge. For companies in dire need of cash, this can be a great option. Also you will want to consider how your customers will react to essential being turned over to a collection agency.
