Factoring for Fast Cash?
I always enjoy reading about new entrepreneurs and their businesses, and in the May 15th edition of the Denver Business Journal, there was an interesting article about an entrepreneurial business that had developed a new twist on accounts receivable lending known as “factoring”. They are using Crowd Funding as the source of their funds….great idea!
As I was reflecting on the article, it occurred to me that while “factoring” is probably the 2nd oldest profession, do businesses really understand when it is financially smart to borrow this way?
Accounts receivable factoring is fundamentally, when a third-party (factor) will purchase your accounts receivable and provide a quick influx of cash to your business. It’s a fairly simple concept, but one that can get complicated quickly…the devil is in the details. So let’s review the pros and cons of this form of financing.
- Fast Cash – 2–10 days after billing
- No credit check of your company
- Maintain current working capital for inventory and growth initiatives
- Save time – outsourcing accounts receivable management can free up your time to focus on marketing, sales and other revenue producing activities
- No additional collateral required
- Business ownership unchanged – not selling equity or taking on partners to generate cash
- Stigma with your customers – customers are notified when factor purchases your A/R and may wonder if you are having cash flow problems or even going out of business
- Loss of control – factor may determine certain customers are not credit worthy for A/R
- High Cost – can be very expensive! 20%+ of factored A/R!
- Long-term contract – you may have short-term cash needs but factor may require longer contract commitment
- Low advance rates – the amount advanced by factor is determined by your customers credit. Bad payment history or bad credit = low cash upfront
- Not a collection agency – you still carry the risk of uncollected A/R
Factoring accounts receivable continues to be an alternative financing for start-ups and growing companies. Despite the cons it can be a viable strategy for small businesses. Just remember that any time you increase your cash flow through borrowing it will negatively impact your profit…always! As a CFO, I would consider the following before making the recommendation for utilizing factoring:
- Know how you’d use the short-term increase in cash flow:
- Good – increase a proven revenue stream
- Bad – testing a new revenue stream
- Good – overcome a predicable temporary cash flow shortage (e.g. seasonal sales)
- Bad – generate faster cash flow without a specific plan for the cash
- Understand the negative impact on your pre-tax net income:
- Example: If you factor 50% of your receivables at a cost of 20%, the effect on your pre-tax net operating income equals 10%
- If your pre-tax net income is 10% or less, you will be operating at a loss
- Identify your specific needs and shop the market for the best fit, a.k.a. negotiate
- Explore your options to understand if there better less expensive alternatives for short-term financing
- Understand how this fits into your financial strategies for the business
Factoring your accounts receivable should be part of an overall strategy for your business. It should never be a knee-jerk reaction to increasing your cash flow. If you are considering factoring, please give me a call. I enjoy helping you gain financial intelligence for your business.