Factoring Receivables: A Simple Way to Free Up Cash from Unpaid Invoices

If your business is experiencing cash flow difficulties, account receivables factoring could be the ideal solution. With receivables factoring, you can quickly generate cash by selling your accounts receivable or invoices. Factoring receivables is a common practice that has been used to manage cash flow by businesses worldwide for centuries. Indeed, the Commercial Finance Association reports that receivables factoring transactions in the United States alone exceed $60 billion per year.

The Advantages of Factoring Receivables

Factoring receivables has a number of advantages. A significant reason is that it enables you to immediately access cash owed to your business. This reduces the need for some businesses to incur debt to fund operations while they wait for invoices to be paid.

Another benefit of factoring is that it results in a more consistent and smooth cash flow. Rather than worrying about whether or not you will receive payment from your customers, you can accurately predict when you will receive payment based on the terms of your receivables factoring relationship. Typically, businesses must wait 30, 60, or even 90 days to receive payment on invoices for delivered products or services. During this time period, the funds are restricted and unavailable to the business. However, factoring receivables can shorten billing cycles and improve cash flow.

Additionally, factoring eliminates your need to manage your own collections. Factoring companies are owned and operated by professionals who specialize in invoice collection and tracking. This results in a decrease in overall bad debt and fewer headaches for your business.

Receivables factoring can provide you with cash within 24 hours, allowing you to effectively address short-term cash flow constraints. Additionally, it can assist you in the following ways:

• Accelerate cash flow, making payroll, tax payments, and order fulfillment easier.

Increase sales by offering better terms to large customers.

• Provide credit to large customers without requiring COD.

• Pay suppliers more quickly; take advantage of early payment discounts.

• Purchase machinery, inventory, and supplies.

Qualification for Factoring Receivables

Almost any industry that generates commercial invoices is eligible for and utilizes receivables factoring. In general, factoring can benefit your business if you pay for labor or materials prior to receiving payment from your customers. Alternatively, if your business is growing faster than you can generate additional working capital—whether from private sources or a bank—factoring may be able to provide the cash you need to maintain steady growth. Additionally, if you own a small business that does not qualify for bank financing, factoring may be the best option for you.

To qualify for receivables factoring, your business must meet two basic requirements. There cannot be any existing primary liens on your invoices, which means that no other company should be able to claim payment when it arrives. Additionally, your customers must be credit worthy. The factoring company will evaluate your customers based on their proclivity to pay their invoices promptly.

Candidates for Factoring Receivables

Is your business a good candidate for factoring receivables? Factoring your receivables may be the ideal solution if:

• Protracted billing cycles wreak havoc on your business’s cash flow.

• Are you spending an inordinate amount of time collecting from late payers and not nearly enough time building your business?

• The bank has denied your application for a traditional loan due to your insufficient business experience, profitability, assets, or overall financial strength.

• Your business could boost sales by offering more favorable terms to new and larger customers.

On the other hand, receivables factoring may not be the best option if your business operates at a loss—less than 10%. Receivables factoring is also ineffective if your business has sufficient working capital and a healthy cash flow.

How It Operates

Factoring receivables essentially involves liquidating or selling outstanding invoices to a factoring company in order to obtain immediate working capital. The company purchases the invoice from you for a slightly less than face value cash advance and then collects the full amount when the receivable is due. Once the factoring company has received full payment for the invoice, you will receive the balance—less a fee. Generally, the factoring fee for receivables is between three and five percent of the invoice value.

While factoring companies have varying fee structures, factoring fees typically include the following:

• Advanced funding – When you submit an invoice for factoring, you will typically receive 70 to 90% funding of the invoice amount within 24 hours of its verification. The funds are then wired to your business’s bank account.

• Discount rate or factoring fee – The factoring fee can range between 2.5 and 3.5 percent per month, or.

1% for each day the invoice remains unpaid following factoring. (Factoring fees can be tailored to your business’s and customer base’s specific requirements.)

• Remainder of the advance, less the factoring fee or discount rate – When your customer pays the invoice, you will receive the remainder of the advance, less the factoring fee or discount rate.

The following is an illustration of how receivables factoring works. Assume you have a customer, XYZ Company, who owes your business $100,000 for a recent shipment of your gadgets. XYZ Company is a large customer with excellent credit, but they never pay their suppliers (you) before 45 days have passed. Rather than waiting 45 days for payment on your $100,000, you decide to utilize receivables factoring. The factoring company verifies your invoice to XYZ Company and wires you 80% of the $100,000 ($80,000) within 24 hours.

If you use the same discount rate as previously stated and XYZ Company pays the $100,000 invoice in approximately 45 days, this equates to a factoring fee of 4.5 percent of the original $100,000 ($4,500). Given that the factor has already advanced you $80,000, you will receive the remaining $20,000 less the factoring fee of $4,500 ($15,500). You will ultimately collect $95,500 of the initial $100,000 invoice.

Bear in mind that the percentage charged by a receivables factoring company is typically higher than the interest rate charged on a short-term commercial loan. As a result, factoring is most effective when used to generate immediate cash—not as a long-term solution. Additionally, receivables factoring companies profit from the volume of invoices they purchase. As a result, you may have a slightly more difficult time locating a factoring company if your invoices total less than $10,000.

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