One of the major goals of any small business owner is to produce consistent but increasing cash flows, Erratic cash flows are not only perceived as instability, but can significantly reduce the efficiency of operations. Having adequate working capital reserves and the ability to purchase or manufacture inventories in line with sales allows labor and resources to be used with maximum efficiency without operating slack.
To increase cash flows, owners can manipulate the amount and timing of inflows and outflows. Improving the number of purchases and the collection of credit sales are two methods used to increase the amount and timing of cash inflows. When trying to increase working capital, it really doesn't matter how many credit sales the firm makes if it cannot turn them into cash quickly. Many small businesses that face liquidity problems do so because of the company's inability to turn over its receivables in a short period of time.
Asset factoring is a way for small business to turn their receivables into cash and transfer the collection risk to an external party. By selling its receivable assets at a discount to face value the company can have access to the funds immediately to reinvest into the business. For most companies, the additional investment return that can be achieved by increasing cash flows and investing money into the business 30, 60, or even 90 days earlier than they would be collected is much greater than the money that is paid to the factor in the form of the invoice discount.
Factoring works in the following ways. A commercial finance company, known as a “factor”, buys all or some portion, of the company’s receivables at a discount. The difference between the receivables book value and the discounted value determines the buyer’s potential profit. The factor, which is usually better resourced, and better skilled at collecting the past due invoices, takes on the collection risk in order to buy the receivables at less than face value. The type of business the company is in, the credit quality of its customers, and the age of the receivables are all risks that will impact the receivables discount rate. For companies that use factoring as a normal course of business can probably expect to pay a discount anywhere from 2%-5% depending on the type of sales and the quality of its receivables. Those that use factoring as a last resort to relieve their cash crunch and increase cash flow can probably expect to pay much more. However, instead of collecting their credit invoices, the selling company can receive cash as fast as the next day.
Asset factoring is a cash flow enhancement method that is used in almost every retail business. Retailers that accept credit cards usually pay a percentage of revenues (usually 1%-3% of the sale) and other fees to the credit card company to allow its customers to buy goods and services on credit. Although the proprietor doesn’t collect 100% of the sale, it does receive the cash right away and does not have to contact the customer to get its money. In fact, most businesses would rather have its customers pay by credit card instead of personal check, if personal checks are even permitted. The chance of getting a bounced check is much more expensive than the small charge that has to be paid to the credit card company.
A lot of very small businesses that cannot afford a collections staff may outsource the collection function to a factoring company or other fee based service. In some cases, the factoring discount is not much more than the collections cost, especially when you consider the reduction in stress and risk of not having to manage the collection function.
Selling receivables to a factoring company will increase cash flow, receivables turnover, and provide immediate access to cash. However, factoring can also provide other benefits. For example, most factoring services are resourced to do all the customer credit checks and sets credit limits for each customer, based on their payment history. In addition, factors will also collect information from your customers that can be used in marketing campaigns. For larger businesses, the factoring company will work closely with the seller and act as the fulltime credit manager, accounts receivable staff, and collection agency.
Although some firms have decided to use asset factoring as an ongoing strategy, other companies will use it as a temporary tactic, to help bridge a period of decreasing working capital reserves. As a temporary solution, factoring can be used to put the receivables back on track, increase cash flow and help companies build the procedures to do collections internally. Some companies will use factoring to strengthen their balance sheet to attract investors or in preparation of a sale.
The analysis that is necessary to determine whether factoring is a valuable operating strategy is the same as deciding whether to use prompt-pay discounts, or to delay payments to vendors. First you must research the potential costs of cash flow factoring for your particular business. Once you determine the cost of factoring for your business you can integrate into a cash flow forecast to determine its potential return. In addition to increased cash flow, in some cases the return from having immediate access to funds that can be reinvested in the business as inventory can produce considerably more income than the fees that are paid to the factoring company. In addition to the income benefits and direct cost of cash flow factoring, you should consider the additional benefits like the time savings or reduction in labor cost for not having to collect past due invoices.
Ultimately your business’ ability to use factoring to increase cash flow and working capital will be a function of the impact of your customer’s late payments on the quality of your earnings stream and your business credit. Cash flow instability and problems paying short-term obligations will affect business credit and credibility. If successful, factoring can be used to help build a company’s overall market reputation.