One of the biggest challenges that an entrepreneur faces is the management of cash flows. It is never easy to accurately predict when your customers will pay. On the other hand, there are often payments to be made that are difficult to anticipate. Business owners spend a great deal of time handling cash flows and ensuring that they are in a position to meet all their financial commitments.
Many businesses have found that factoring or the process of selling their invoices or accounts receivable is an efficient way to convert sales into cash. By utilizing the services of a factor, business enterprises can improve their liquidity position and simultaneously avoid the inconvenience of collecting amounts due from their customers.
How does factoring work?
When a business makes a credit sale, payment is normally due within a pre-decided period of time, normally 30, 60, or 90 days. Usually, the seller would have to wait for a month or more to receive cash against the sale. But a business may have an immediate requirement for funds.
In such a situation, a factor could buy the invoice and pay the seller immediately. In the normal course, the amount paid would be about 80% of the invoice value. Subsequently, on the due date, the factor would collect the entire amount from the buyer. At this point in time, the factor would pay the remaining 20% of the invoice value to the seller after deducting its charges.
Who should use it?
There are certain categories of businesses that cannot use factoring. Any business that sells at a retail level will not be able to take advantage of this means of financing because factoring requires a credit sale to take place.
Businesses with sound credit ratings also generally do not use this method of raising funds. They are able to access finance at rates that effectively cost much less than what a factor charges.
Factoring is extensively used by firms that have large volumes of business-to-business sales on credit. Significantly, factoring services are not dependent upon the credit rating of the company that is selling its invoices. Instead, the rating of the buyer is critical. This allows new firms and businesses with poor credit ratings to raise money using factoring.
Factoring offers great convenience
Another reason that factoring has gained great popularity with small businesses is the ease with which funds are made available to sellers of goods and services. A business can get money in its bank account within 24 hours of delivering the invoice to the factor.
Additionally, there is very little paperwork involved and the seller does not need to worry about staffing its credit and collections department as this work is handled by the factoring company.
Although factoring can offer great benefits to a small business, it is advisable to take a few simple precautions before deciding on which factoring company to use.
If your business sells goods on a returnable basis, avoid using a factor. Sorting out the complications that result from the cancellation of an invoice for goods that have been returned can be very difficult.
Understand the fees and penalties in your contract with the factoring company. Most factoring companies charge a processing fee and a factoring fee. The processing fee is a percentage of the invoice amount and is linked to the credit period after which the buyer will pay. The factoring fee is levied for delays in payment by your customer to the factor.
While factoring offers great convenience, it can turn out to be a costly source of finance. A little research on the terms and conditions offered by various companies could save you a lot of money.