In order to build cash flow and liquidity, businesses can follow a wide range of strategies. One strategy that many businesses use that can help them to raise capital, build liquid reserves, and improve their short-term cash flow is a process called factoring. But what is factoring?
This article will discuss exactly what factoring is. We will also see what the advantages of factoring are, and what are its disadvantages.
What Is Factoring?
For those who are wondering what is factoring, first understand how accounts receivables work. When most businesses offer a product for sale to a commercial client, they will give terms that allow the client to pay its invoice within 30 to 60 days. In some situations, the terms of payment could be even longer. This happens especially if it is to a highly credible client. This can help any business to increase sales by offering better terms. However, it also creates a cash flow crunch because they likely will not get paid for at least one month after selling the product. The unpaid balance is then recorded as an accounts receivable.
There may be a better option to factor the receivables, especially for those businesses that:
- Are concerned about the cash flow crunch;
- Do not want to deal with the hassle of collections;
- Have other concerns that they may not receive the payments.
When factoring the receivables, the business will sell the receivables to another party that will act as the collection agent. The collecting party will then collect in the name of the business and we’ll have full rights to whatever amount there is. Due to the collection risk, the business will sell the receivables at a discount that depends on the overall risk that appears there.
3 Key Advantages of Factoring
For those that are wondering what is factoring and what are its advantages, there are many benefits that come to those that successfully Implement a factoring strategy.
- One of the main benefits of factoring is that it can provide you with better cash flow. When you decide to sell your receivables to the buyer, the business will instantly receive the cash payment. This can provide a business with an instant amount of cash. This comes in opposition to waiting for months for it.
- When thinking about what is factoring, another advantage is that it can help to reduce overhead costs. For businesses that have a lot of outstanding invoices and many different clients with differing repayment terms, collecting receivables can be a time-consuming and expensive process. This will often require hiring multiple staff members. By selling the receivables directly to someone that is willing to buy them at a discount, you can reduce the amount of administrative expenses.
- The third advantage of factoring is that it can reduce your collection risk. Whenever you complete a sale to a customer and do not collect cash up front, you are taking on the risk that they will not ever pay you. This can lead to a complete write-off and unexpected loss if the customer ever goes bankrupt or decides to default on its debt to you entirely.
2 Possible Disadvantages of Factoring
While there are some clear advantages that come with factoring, those that are wondering what is factoring should also keep in mind that you can meet an inconvenient as well.
- The main and clear disadvantage of following a factoring strategy is that you can ensure that you will be losing a percentage of every sale. When you sell accounts receivable, you will likely lose at least 5%. This is regardless of how current the payment is and who the customer is. If you are operating on lower gross profit margins, this loss could greatly eat into your overall profit margins.
- Along with this, when you take advantage of a factoring strategy, you will also lower the ultimate value of your business. By accepting a lower net income, you are reducing the ultimate valuation of your company.
How Factoring Optimization Works
When wondering what is factoring, another thing that you should consider is how you can optimize your factoring process. One way that many businesses try to optimize their factoring process is to only sell receivables that are past due. Most businesses believe that they can easily collect on receivables that are current or with value clients. However, if a receivable starts to go further past due than 90 days, it could begin to look uncollectible. In these situations, it could be a good idea to sell the receivables to a third party. However, when you only sell the more toxic receivables, the sales rate that you receive will also be much lower.
Another financing option that is available to those with accounts receivable is to open up a working capital line of credit with the bank. If you have a relationship with a bank, the bank will likely be willing to provide you with a line of credit that is secured by your AR. Also, when you have one of these loans, you will be able to:
- Borrow against your outstanding receivables;
- Pay down the loan balance when the money comes in.
This can provide you with more interim liquidity. However, you will still run the same collection risk and will have to pay interest.
In the End
In conclusion, having good liquidity and cash flow is extremely important for all businesses. For those that are looking for ways to maximize their equity and short-term cash flow, one of the best options would be to take advantage of accounts receivable factoring.
There are a variety of advantages and disadvantages of factoring that you need to be aware of before following the factoring strategy. Furthermore, once you have decided to start following a factoring strategy, there are steps that you can take to try and minimize the risks and disadvantages.
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