• May 19, 2015
• By Rick Arthur
• In cash, cash management
• No Comment
• 4

I always enjoy reading about new entrepreneurs and their businesses, and in the May 15^th 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 2^nd 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.

Pros:

• 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

Cons:

• 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.