Reduce Stress Improve Cash Flow
Money problems can create more stress than almost anything else. Every owner of a business knows this is true, but from time-to-time all small businesses will have cash flow issues. Whether caused by an unexpected expense or issues with collection of accounts receivable, a lack of money for payroll, rent or other expenses can hurt credit, create a lot of stress and threaten the very survival of the business itself.
For any business that is consistently generating accounts receivable, a possible solution to cash flow problems is a 4,000 year old financial tool called factoring. Many Fortune 500 companies such as Hewlett Packard, Applied Materials, Bethlehem Steel, Xerox and Lucent Technologies have used invoice factoring as a form of business financing.
Factoring is the sale of an account receivable in exchange for an immediate advance of between 50% to 90% of the invoice face value and a rebate of the reserve, less the factoring company’s fees, when the invoice is paid.
How Factoring Works
The diagram below shows how a factoring transaction works for a $5,000 invoice.
In this example, the factoring advance is 80%. If the total fees charged by the factoring company are 3% per month and the $5,000 invoice is paid in 30 days, your business would receive a factoring advance of $4,000 when the invoice is factored and a rebate of $850 thirty days later when your customer sends the $5,000 invoice payment to the factoring company. The total cost of this factoring transaction to your business would be $150.
Benefits of Factoring
Invoice Factoring offers a small business many benefits.
- Immediate Cash – When a factoring account has been set up, your business can receive cash on the same day as when you submit the invoice for purchase.
- Your Credit is Not an Issue – When your business has delivered goods and/or services to your customer, the only credit issue is the financial strength and payment history of your customer. Your personal credit and the credit of your business is not an issue.
- Manages Slow Pay Customers – Customers who slow pay their invoices can negatively impact the cash flow of your business. By factoring the invoices of your slow paying customers, you convert a problem into an opportunity.
- Does Not Increase the Debt of Your Business – Invoice factoring is not a loan, so when you factor an invoice you convert an asset into cash but your business does not create any additional debt.
- Helps to Manage the Cash Flow of Your Business – Because you control how much of your accounts receivable you wish to factor and when you wish to turn them into cash, invoice factoring can give you total control over the cash flow of your business. If you have an unplanned expense, you can use factoring to pay it.
- Can Help Improve Your Credit Rating – When the cash flow of your business is effectively managed, you will be able to pay bills on time, which will help to improve your credit rating.
- Much Easier Than a Bank Loan – Because the credit rating of your customers is more important than your personal credit rating or the credit rating of your business, getting approved for invoice factoring is much easier and much quicker than getting a bank loan.
- Does Not Dilute Ownership – Unlike the sale of equity in your company, factoring does not dilute your ownership or add other owners to your company.
Some Issues to Consider
Although invoice factoring offers a small business many benefits, there are some important issues to consider before entering into a factoring agreement.
- Gross Profit Margin – All factoring companies will charge fees on the basis of the amount of time it takes for an invoice to be paid. The average fee a factoring company will charge is 3% per month, so it is important to make certain you have sufficient gross profit margins on the invoices you factor.
- Watch for Hidden Fees – Many factoring companies charge hidden fees that you will not know about until you start receiving bills for their services. Some of these hidden fees can be charged for account set up, credit search, payment processing, document recording, monthly audits, rebates and agreement termination. Some factoring companies also charge fees in 10 day segments without regard for whether the invoice is paid on the 1st or 10th day of that time period.
- Avoid Long Term Factoring Contracts – Some factoring companies will ask you to sign a long-term agreement and then charge a high termination fee is you wish to cancel the agreement.
- Control When and How Much You Factor – As a way to increase their revenue, some factoring companies will demand that your business factor all invoices and they will also start their fees running on the date of the invoice, not when the invoice was purchased. Make sure you have complete control over what invoices you submit for factoring and when you start paying fees.
- Invoice Assignment – All factored invoices must be assigned to the factoring company; and this requires that your customer agrees in writing that they will (i) designate the factoring company as the payee for all factored invoices and (ii) send all payments for factored invoices to the factoring company. In some situations (ie. Defense Contracting), you may be prevented from assigning your right to receive payment.
Factoring Compared to Other Forms of Business Financing
Bank Loans – Since the international banking meltdown in 2008, it has become very difficult for a small business to get a traditional bank loan. Issues a company with average to poor credit will face when applying for a bank loan include the following:
- A Lengthy and Complicated Application Process – Getting a bank loan requires submission of full documentation about your business and personal financials and can take months to complete, with no guarantee that the loan will be granted.
- Difficult Qualification Requirements – Borrowers with less than perfect credit will have a very hard time getting a bank loan. Credit card payment defaults, foreclosures and god forbid, a bankruptcy, are all reasons for a bank to say NO to a loan request.
- The Need for Collateral – Banks do not give loans without filing a lien on tangible assets that are worth as much or more than the loan amount.
- Limited Funding Amount – A bank loan provides a limited amount of money that cannot be increased without going through the entire application process again.
- Long Term Agreements – Most bank loans are typically set up with 3 to 5 year repayment terms, which means your collateral will be tied up and not available for other purposes for that entire time.
- Use of Proceeds – The lending bank will almost always dictate how the proceeds from a bank loan can be used. The use of proceeds for any other purpose can trigger a default.
- A Lower Interest Rate – One benefit of a bank loan is an interest rate that is generally lower than the fees charged for factoring.
Purchase Order Financing – For a business that needs money to satisfy purchase orders from their customers, a good form of funding is purchase order financing. PO Financing will generally provide funding for raw materials, vendor services and labor in an amount that is up to 50% of the total amount of the purchase order. Another requirement of PO Financing is that the order must be fulfilled and an invoice issued within 90 days of when funding is provided. With many asset-based lending companies, the PO Financing advance and fees will be paid through the factoring of the invoice generated when the purchase order has been satisfied.
Below is a diagram showing how a typical purchase order financing transaction works.
Line of Credit Financing – A line of credit is a revolving loan with a maximum amount that acts like a bank account, allowing you to withdraw money out of when you need it and put money back into when funds are available.
A Line of Credit offers several benefits: (i) a Line of Credit can quickly cover financial shortfalls; (ii) you decide how much money you need and only pay interest on the amount you use; (iii) an asset based Line of Credit is secured by the accounts receivable of your business, so the credit ratings of your customers are more important than your credit rating; (iv) proper management of a Line of Credit will improve your credit rating; (v) a Line of Credit can stay in place for years without the need for an annual re-application like many bank loans and (vi) a Line of Credit will lower your stress because it gives you money for emergencies.
Daily Payment Loans – One type of loan every business owner should be wary of is the Daily Payment Loan. Unlike asset-based loans, the principal security for a Daily Payment Loan is the bank account of the borrower. As the name implies, a Daily Payment Lender has the right to make daily withdrawals from the borrower’s bank account. If there is a default, the lender can wait until money is in the account and remove it all. Other detrimental features of a Daily Payment Loan are (i) the term of the agreement is usually a minimum of one year; (ii) the interest rate is very high (30% to 40%) and is deducted daily with each withdrawal from your bank account and (iii) the total amount due is set and there is no opportunity for an early payoff to stop interest from running. Daily Payment Loan companies are very aggressive about declaring a default and taking action to collect, so great care should be taken before entering into one of these agreements.
When Invoice Factoring Should Be Used
There are some very specific times when invoice factoring will be most beneficial for a business.
- Creating Accounts Receivable – Only companies that are consistently creating a minimal level of accounts receivable with credit worthy customers are able to use invoice factoring as a cash flow management tool.
- Business to Business – Because of credit verification issues, it is difficult to factor accounts receivable for companies that principally provide services to individuals, so only companies engaged in B2B transactions are able to factor their accounts receivable.
- Slow Pay Accounts – Companies with accounts that consistently slow pay their invoices can use factoring to quickly convert those invoices into cash whenever the need arises.
- Fluctuating Cash Flow – Any company with erratic income or expense will find it difficult to get bank financing but they can even out cash flow by factoring accounts receivable.
- Growing Business – Invoice factoring is a perfect financial management tool for a growing business. As capital needs increase for inventory, equipment, payroll, marketing or any other expense, the amount of immediate funding available from factoring can meet these needs.
- Credit Issues – The factoring of accounts receivable is possible even when credit issues prevent a company from getting financing from a bank. With invoice factoring, the credit of the customer is more important than the credit of the borrower.
- Sufficient Profit Margins – Depending on monthly volume, invoice factoring typically costs between 2% to 3% for each 30 days that an invoice is unpaid. Because of this expense, it is important the average gross profit margins of a business that is factoring invoices are at least 15%.
- Account Imbalance – Many companies find that a very few of their accounts represent more than 50% of their total income. Waiting for the payment of these large invoices can put a real strain on a company. With invoice factoring, immediate access is provided to however much money is needed from large invoices to keep things going.
- Large Expenses – All companies face large expenses that arise from time to time. Whether this is a tax payment, a worker’s compensation deposit, an insurance premium or a down payment for a new vehicle, the cash provided by invoice factoring can cover these expenses when no other funds are available.
- Emergencies – All companies will eventually face a financial emergency. With a factoring account set up, it is possible to get immediate funds for any business purpose without the need to go through an application process or wait for money.
Invoice factoring is a powerful cash flow management tool that can effectively be used by companies with the right business profile. The keys to a successful factoring relationship are as follows:
- Make sure your company will benefit from invoice factoring
- Carefully select the right factoring company for your needs
- Ask questions and make sure you understand all terms of the factoring agreement
- Analyze the cash flow needs of your business so you can anticipate when and how much of your invoices you will need to factor
- Discuss financial issues your business is facing with your factoring company and work together to quickly resolve any issues.
For more information about how invoice factoring might benefit your business, please contact Ben Gage, Chief Operating Officer of Diversified Business Resources, Inc. by email at Ben@dbrfactors.com or by phone at (760)738-1400.