Need immediate access to cash? Factoring provides just that—but first know its advantages and disadvantages.
Factoring is when a third-party firm, or factor, “buys” a business’ accounts receivable and gives the business a cash advance based on those unpaid bills. The third party then takes over collecting the owed receivables. The process allows the business access to cash faster, rather than waiting 30 or 60 days to collect payment from customers.
It’s a form of financing used by companies to maintain cash flow. It’s more common in certain industries where immediate cash is necessary to operate the business, like staffing, textile and printing firms. Factoring is also what Michael Napolitano, a CPA at Citrin Cooperman & Company LLP in Springfield, N.J., calls “second-tier financing.” If a company is considering factoring but isn’t part of an industry where factoring is common, it is probably because a bank isn’t lending them money for one reason or another, Napolitano says.
If you are considering enlisting a factor, keep the following points in mind:
Time Savings. Factoring can save you time and effort that would otherwise be spent on collecting from customers. That energy can be redirected to other business-building endeavors, like sales, marketing and client development.
Good Use for Growth. You can use the instant cash to generate growth, maybe hiring another salesperson who will bring in more business. Or buying an advertisement that will reach new customers. Or buying a piece of equipment that will accelerate production.
Doesn’t Require Collateral. Unlike traditional bank loans, factoring doesn’t require you to risk your home or other property as collateral.
Qualify for More Funding. Factoring firms will typically give a cash advance on up to 80% of your receivables, says Napolitano. That may be more than you would be able to get from a bank.
The Stigma. The most common thing small business owners don’t know about factoring, Napolitano says, is that their customers are notified when a factor takes the receivables over. “The customers are no longer paying you, they’re paying the factoring company,” he says. That may alert them to your cash flow trouble.
Less Control. Once you accept cash for your receivables, you give up a measure of control. For example, the factoring company could deny your ability to do business with a particular customer because of its poor credit history or rating, says Napolitano.
The Cost. While it may be necessary to have immediate access to cash, it will come at higher price than loans. Factoring companies usually keep between 1% and 4% of a receivable as their fee. Additionally, Napolitano says, they charge interest on the cash advance, typically at prime rate plus 2%. That all can add up to more than 30% in annual interest.