Recently you may have heard something about accounts receivable factoring or invoice factoring. You may have wondered what exactly is factoring. Factoring refers to the selling of your company’s accounts receivable at a discounted rate.
At this point you may be wondering why anyone would want to sell their accounts receivable for less than their face value. Two reasons come to mind.
The first one, the more common of the two, is that a company is in dire need of cash. Most business experts agree that lack of cash is the number one reason that business fail. Let’s look at an example of when a company might want to consider factoring invoice.
A start-up or growing company that sells luxury yachts is having a blockbuster year in terms of sales ($10 million dollars in revenue). However the nature of the luxury yacht industry is that most clients are not going bring cash when they buy the yacht (if they do, then as the owner of the business you might be a little worried). The business owner has sold out his entire inventory and does not have the cash to buy more. The poor guy barely has enough cash to pay his employees. He has already taken out a loan to finance the yachts and his debt ratio makes it so nobody is interested in lending him more money. He does however have $10 million in accounts receivable.
At this point the owner may want to consider business invoice factoring (selling his accounts receivable at a discount). This would allow him to pay his employees and purchase new inventory.
The second reason to consider invoice factoring services is widely considered unethical. This is done when as an owner you know that your accounts receivable are not worth much and you feel you can get more money from a factoring company. This is hard to pull off because most factoring service companies do their homework before buying accounts receivable.
Benefits of Factoring Invoice Discounting
Probably the biggest benefit of selling your accounts receivable is that it frees up some much needed working capital. This is especially true for companies that have a loose credit policy and a lot of money tied up in inventory.
Another advantage of factoring is that it shifts the burden of collection to someone else. After you sell your AR it is up to the factoring company to collect. Warning: they may be more brutal with your customers than you would be so make sure to get to know the factoring company’s collection process before selling your AR.
Disadvantages of Invoice Factoring
Cost is the number one disadvantage. The discount rate will vary from company to company, but in many cases selling your accounts receivable will be more expensive then opening up a credit line. Most companies should view factoring as a last result – before bankruptcy.
Customer service is another big disadvantage. If your company relies on strong relationships with its customers, then you will want to consider how the customer will feel if someone else is going to be contacting them about their payments. In many cases this is a non-issue because your customers are making their payments on time. However, if a customer falls behind on payments, remember that the invoice factoring company may not treat the customer how you would.
Another interesting disadvantage is that it complicates the accounting. If you don’t have some skilled accountants, then they may not know how to appropriately handle this type of transaction. You can always work with an accounting services firm to avoid having this problem.
Who Collects /Deals with the Customer Now that I’ve Factored My Accounts Receivable?
In all cases your company can still have contact with the customer and try to make repeat sales. In some cases you may still be the one that collects payments, but then you have to send them to the factoring company. In other situations, it will be completely up to the factoring company to make collections. Make sure to carefully examine the contract and work this out before engaging in factoring.
What is the Cost of Factoring Invoice?
To better understand the cost of invoice factoring, it helps to see an outline of how everything takes place.
1. Your company provides goods and services on account.
2. Your company sells these accounts to a factor. At this point the factoring service usually gives your company somewhere from 60-90% of the invoice value.
3. The customer pays off his/her account.
4. The factor pays your company the remaining 10-40% but with a fee.
This fee is where the factoring company makes its money (and hence is the cost to your company). This fee is usually around 2% to 4% of the invoice per month. This can add up to be an expensive way of financing, but you also don’t have to wait to receive the cash from your accounts receivable. As with most business decisions you need to do a cost-benefit analysis to see if accounts receivable factoring is a good idea for your company.
