7 Aug 2011 | Small Business
Businesses that sell their goods and services on credit can sometimes experience poor cash flow that restricts their development. This is especially the case when a business experiences rapid growth in revenue. If the business cannot offer bricks and mortar security their chances of raising finance to help them through the cash flow problems is much reduced.
An alternative to traditional borrowing sources is factoring, or accounts receivable/debtor financing. What was once regarded as a method of financing by desperate and financially troubled businesses, has now become a more main stream source of business funding.
Factoring is charged as a discount or administration fee on the amount collected. This fee can vary between 0.05 per cent up to 5 per cent and more. At the higher fee this can prove to be an expensive form of finance.
When a business has to choose between doing nothing, or factoring using its accounts receivable, this costly form of finance may be the only alternative. A profitable business could find by not factoring that it cannot sustain its growth or even face the risk of operating insolvently by not being able to pay its debts on time.
Because of the wide range in the cost of factoring it is important to shop around. It is also important to compare not only the different cost structures but also the different services offered by factoring companies.
There are two main types of factoring. The first is traditional factoring where a business advises the factoring company of how much it has invoiced customers. The factoring company pays 85% of the value of those invoices to the business, then administers the debt and collects the money on behalf of the business. Once the debt is collected the business receives the balance of the value of the factored invoices, after the factoring fees have been deducted.
The second type is called invoice discounting. Under this method the factoring company is advised when invoices are raised and it pays receives 80% of the value of those invoices. When customers pay their invoice the proceeds are banked into an account operated by the factoring company. The factoring company then pays the balance of the value of the invoices after deducting its fees.
In the majority of cases where traditional factoring is used customers of the business know their account has been factored. With invoice discounting a customer may never know what method of financing is being used. This is because the business requiring the funds still administers the collection of its accounts receivable.
For invoice discounting to work the business requiring the finance needs to have an efficient accounts receivable system. This method also requires the factoring company to place a higher level of trust in the owners of the business being advanced the funds. Where a business partnership uses invoice discounting non-working partners can face huge debts if the working partner does not meet the obligations to the factoring company.
This situation will occur when the working partner starts banking some of the cash received from discounted invoices into a second business account, instead of the factoring company’s bank account. This results in an increasing debt to the factoring company. Although the non-working partner has not been responsible for creating this debt, where the working partner has no assets, they would still have to repay it.
Factoring and invoice discounting can provide finance for a business that has no other options. It should not be considered as a viable long-term method of financing due to the high costs associated with it.