Factoring is a form of financing that gives your business quick liquidity. If you have accounts receivable, that is, invoices with payment due, then you may want to look at this type of financing as a way to increase cash flow. Understanding this process is the first step to deciding whether or not it may be the right solution for your company.
How It Works
When you apply for this type of financing, you sell your accounts receivable at a discount to a third party known as a factor. The factor pays you a percentage of the total amount due on the invoices. After the lender collects on the accounts receivable, you receive the remaining percentage. Many businesses turn to factoring when they need additional cash flow and aren’t eligible for other types of financing. The reasons for this can vary, but two of the most common circumstances are when your business is new and doesn’t have an established client base and when your business has a poor credit history. As long as you have accounts receivable, you can apply for this type of financing.
This type of financing offers a relatively quick process when compared to other methods such as traditional bank loans. For businesses whose credit score isn’t high enough to get approved for a bank loan, this is an alternative way to access capital. When used as a short-term cash management tool, it can provide an influx of cash to fund a necessary purchase without having to wait for customers to pay their invoices. Plus, once you sell your accounts receivable to a factor, you are no longer responsible for collecting payment, which eliminates an administrative burden.
Although it’s an attractive way to obtain cash flow, this type of financing doesn’t come without some potential risks and drawbacks. Collections is a delicate matter, and it’s important that the company that takes over the job for you doesn’t damage relationships with your clients in the way they collect on your invoices. Do research on the lender to make sure they are reputable. Be clear about the terms of the financing contract. In some contracts your personal assets may be used as collateral if your customers don’t pay their invoices.
Knowing the benefits and possible risks in factoring will help you decide if this type of financing is right for your company. Under the right conditions, it can be a helpful way to increase capital to grow your business.