Accounts receivable financing is becoming a well-known way to leverage some of your assets in an attempt to create steady cash flows. There are many different ways to factor and chances are you have heard it explained differently by different people. Although financing accounts receivable may take on many shapes and forms the overall idea remains the same: using the companies’ receivables to obtain cash from a third party. This article will briefly explain how factoring works and then it will attempt to clear up any misconceptions on the matter.
How does accounts receivables financing work?
I find that examples work best when describing processes like factoring. Let’s imagine that your name is Joe and you own an electronics store. Your main items are computers and laptops, but you also sell printers, keyboards, networking hubs, etc. You have about three or four big clients who make up about 80% of your business. Then you have a lot of little customers who make up the other 20%.
During a slow year, one of your large customers decides to buy $300,000 worth of computers and laptops. They don’t pay you cash, but give you a receivable that they promise to pay off in 30 days. At first you’re a little annoyed by having to wait 30 days, but hey, you’re just glad to be doing some business right now.
Well after a week or so, you hear something about receivables financing from one of your interns and you decide to try it out. You call up a bank or a factoring company and tell them you have a $300,000 invoice that you want them to buy. They tell you they will give you $290,000 right now in exchange for the receivable. Your company gets the money and the factor takes the receivable. This is the essence of receivables financing. However, this probably only whet your appetite and chances are you have a lot of questions. I’ll try to answer them below.
How much does receivables financing cost?
You’re not going to like to hear it, but it really depends. The most critical factor is how trustworthy your customer(s) are. If they have a long history of making payments on time, then you will get a much better rate. If the customer is large and has a very low probability of going insolvent, then you will get a better rate.
In our example above, the invoice factoring company gave Joe’s company $290,000 out of $300,000 (96.7%) up front. This is known as the cash advance. In reality, this is probably a pretty high advance. If the customer has a good credit history and the industry isn’t extremely risky, then cash advances are usually around the 80-90 percent range. Let’s change our example and assume that Joe only receives 80% or $240,000 up front.
After 30 days the large customer pays off the full $300,000 for the computers and laptops. At this point, the factoring business will normally remit most of the remaining balance. I say “most” because if the factor remitted all $300,000 it would not be making any money and would have no reason to be lending Joe money. Just like any loan, there is an interest rate charged. This interest rate is known as the factoring fee. The factoring fee is the true cost of account receivables financing.
What is the average fee for receivable finance?
Again, the answer depends on several factors: risk in the industry, risk of the customer not paying, risk of Joe’s company going out of business; basically any risk event that may lead the factor to not receiving the invoiced amount is considered. That being said, the average rates are around 1.5 to 4 percent per invoice per month. Let’s go back to Joe’s example to see how much this is costing. Joe had a $300,000 receivable from a large, trusted company that was out for exactly 30days. Joe initially received $240,000 from the factor. The factor and Joe worked out a deal where the factoring fee would be two percent because this is a large customer that has always paid. After the factor receives the money from Joe’s customer, they remit all but (300,000*.02 * 1 month) $6,000 to Joe.
Let’s take a look at whether or not receivables financing has been a good deal for Joe up until this point. Joe’s company was in need of cash and they received $240,000 up front for a receivable that would have taken 30 days to reach Joe. Not bad! Joe was able to use this money to pay employees and invest further in his business. At the end of the 30 days Joe receives a remittance of $54,000 (all but the $6,000 factoring fee). At face value this doesn’t look like a bad thing.
Is accounts receivables financing a good/bad deal?
Well, in our example Joe has essentially paid $6,000 for a one month loan of $240,000. You could argue that the loan was for $300,000 because Joe eventually receives the other $54,000 but initially Joe could not touch this money. Joe has paid two percent for a pretty large loan; sounds like a pretty good rate doesn’t it? Well, you have to remember that was a monthly fee. Over the year, this would be a 12months * 2percent = 24 percent interest charge. This means that if Joe’s company was consistently factoring off their receivables throughout the year, his company would be paying 24 percent for financing.
That sounds like a bad deal. Why would anyone finance receivables?
Before you rush off to write in your local newspapers about how factoring companies are the equivalent of payday loan centers, let’s consider why Joe would want to finance his receivables. Sometimes banks are not willing to loan money or at least not enough money. Maybe in Joe’s case he has already tried getting a loan from the bank, but they have denied him any further credit. In addition, sometimes banks can take a long, long time to get through the loan evaluation process. Factoring companies are much quicker in many cases.
But, it just doesn’t seem fair; it seems like receivables financing should cost less than a normal loan because there is collateral. This is a good point. The only answer I can suggest is that factoring companies provide more than a loan. In a way they serve as a collection agency, freeing up time for your organization to focus on their core competencies. They free up time just like outsourcing your accounting services to a third party does.
Who collects my customers’ invoices me or the factoring agency?
This can go either way in factoring arrangements. Some companies are very reluctant to turn their customers over to a factor who may not treat them as nicely. Other companies want the factor to collect for them. This is something that must be agreed on between company and factor.
Factoring for companies considering bankruptcy?
Many factoring organizations will only consider certain types of bankruptcy (like chapter 11). At the end of the day, it is going to be hard to get any sort of loan if you are considering bankruptcy. That being said, you have a better chance getting cash using factoring because there is some collateral, the receivables.
What if I’ve already promised my receivables to the bank?
Even if your receivables have some form of lien on them from the bank, there is still a chance you can sell those receivables. Make sure to tell the factoring company about the liens and they may be able to work out a deal with your bank.
Can I sell only one invoice to a factor?
Usually factoring companies will want you to do recurring business with them. One time deals are rare unless the receivable is large enough. There are markets out there where you may be able to sell just one account (receivablesxchange.com).
Do I have to sell my receivables or can I just borrow against them?
There are investment companies that will allow you to use your receivables as collateral. This is known as invoice discounting.
If you have any other questions, feel free to ask them below.
