Should Small Businesses Use Factoring?
Many small business owners find themselves needing access to capital in order to grow their business, however, for one reason or another, traditional loans are not always an option. Since traditional lending is not practical for everyone, alternative lending may be a better bet. Factoring is just one type of alternative lending that could be a possible solution for your business.
Factoring, a subset of asset-based lending, is a unique lending model that essentially exchanges a company’s accounts receivable for an agreed term for instant cash. The company can then fulfill an invoice with the borrowed money and receive the balance once the customer pays the factor. This lending model allows businesses to grow and even gain the breadth necessary to qualify for a traditional loan. To break it down:
- You sell your accounts receivable to a factor at a discounted rate
- The factor gives you a cash advance to finance the invoice
- Once the customer receives the order and pays, the factor is reimbursed, and you receive the balance
Small business factoring is cited by many industry observers as the “smart alternative” to bank loans. Just like merchant cash advances, factoring can be a viable option for small business owners as factoring financing approvals aren’t based on the business owner’s credit health, but on the company’s clients’ credit health. Factor financing is also good for small firms facing a cash-flow crunch or slow-paying clients. With factoring, those companies can sell their customer invoices to so-called “factor companies,” that, after approving the deal and weighing the client’s credit, will deliver up-front payments against client invoices and account receivables, of up to 90% of the total amount owed by the customer. After the client makes the total payment owed, the factoring company remits the balance, and tags on a processing fee.
For business owners, the big difference with factors is payment times—instead of waiting 30-to-60 days to get paid by customers, small business owners get access to cash within 48 hours, by opting for the factoring route. As with MCA’s, interest rates linked to factoring are generally higher than bank loans. Still, factoring is proving popular with businesses. The Wall Street Journal estimates the size of the factoring market is in the billions, although much of those assets are tied to specific industries, like trucking, retail, construction, and health care.
What Are the Benefits of Factoring?
It’s often easier to get an approval with a factoring company rather than approaching a bank for a loan. The factoring companies typically care more about the invoice value – somewhat like collateral – and are focused on your customer’s credit rather than your business credit (or lack of credit).
The immediate cash flow is probably seen as the biggest benefit because there may be times when you need immediate working capital to obtain other goals.
What Are the Drawbacks of Factoring?
This method of drawing cash can be costly. If your customer pays late, the responsibility could fall back on your business to collect or, you are paying higher fees up front to avoid that from happening. Either way, over time, this could end up costing more than the value of having the working capital up front. Consider your profit margin, your immediate vs. long term goals and weigh whether this is the best option.
Be sure to go through your due diligence in determining if you have found a reputable factoring company to work with. If the factoring company’s practices are unethical in any way, it could wind up affecting your customer and you could incur the additional damage of ruining your relationship with your customer, which of course would hurt your profitability over the long run.
Immediate cash flow strategies are best developed with the guidance of a financial advisor or financial partner you work with to manage your small business finances. There may be other special products or options depending on your business type, when it comes to equipment and materials you may need to run your business.
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