Many business owners wait anxiously in their mailbox every day to find out how they can conduct business that day. If checks come this early, that’s great – they can pay vendors, meet payroll and tax obligations, and perhaps take advantage of growth opportunities. If they don’t come, it can mean another sleepless night, wondering when all those checks that are “in the mail” will materialize.
This “cash flow contraction” is especially severe for fast-growing companies in industries where customers tend to extend accounts payable beyond 30 to 60 days. The fact is, more businesses fail due to lack of cash flow than due to lack of sales. Slow turns of accounts receivable can literally bleed a business.
Offering open account terms to clients may be part of your cost of doing business, but have you ever thought about what it really costs you? If you’re waiting 30 days to get paid, you can only turn your profitability into more business 12 times a year. Imagine what a 90 or 120 day cash conversion cycle is doing to your cash flow and growth capacity!
Of course, another risk involved in open accounts is the risk of not getting paid. absolutely. In their quest to grow, many business owners offer payment terms to clients with less than stellar credit. Even homeowners who try to be diligent when it comes to new customer credit checks often don’t have the training or experience to spot red flags that may indicate negative credit risks.
The factoring solution
One solution to both challenges is a long-established process that has received renewed attention in recent times as the bank credit crisis has taken hold: factoring. How do factoring services work? Commercial finance companies (known as “factors”) purchase outstanding business receivables at a discount, usually between 2% and 5%. In this way, the company receives the payment as soon as 24 hours after generating the invoice, instead of 30, 60 or even 90 days later.
To better understand how a factoring service works, let’s compare it to what happens when you use a credit card to pay for a retail purchase:
Everyone with a consumer credit card has gone through an application process and has been pre-approved for a particular spending limit, based on their credit and payment history, employment status, etc. With this card, a person can purchase goods and services from a multitude of different product and service providers.
Suppose you are inviting a customer to lunch. You give the waiter your credit card when he brings the check and he quickly disappears behind a half wall to “verify your creditworthiness” by swiping the card through an electronic terminal. If the card is approved, you are allowed to “sign the bill”, thus paying for the service provided: your food. Your next contact with this transaction is when your credit card statement arrives, which has posted the transaction for verification. Then you send the payment to the “credit provider”, which in this case is the bank that issued the card.
But what is happening at the end of the restaurant? At the end of each business day, the restaurant presents the “pre-approved invoices” (ie, credit card receipts) for that day to the bank for payment, “selling” them at a discount. The restaurant does not receive 100 percent of the face value of the invoices, but a predetermined percentage in exchange for being able to give customers the possibility of using the credit in their establishment. The restaurant will generally receive funds from your bank the next business day.
A factoring service does the exact same thing as the bank in this example, but on a commercial basis. The factoring service buys the receivable from the company at a discount and is responsible for collecting it, just as the bank buys a credit card transaction at a discounted restaurant and is responsible for collecting the payment from the customer. Company customer payments are mailed directly to the factoring service’s secure PO box, while restaurant customer payments are mailed to the bank’s post office safe.
The benefits go beyond cash flow
Remember that the benefits of factoring services extend far beyond faster accounts receivable turnover and improved cash flow. For starters, the factoring service performs all customer credit checks to help detect bad credit risks and sets appropriate credit limits for each customer based on these checks. Collecting accounts receivable, monitoring customer credit, and providing Internet-based account information are some of the valuable services that factors provide. In essence, a factoring service can be a full-time credit manager, accounts receivable clerk, and a company’s collection agency all rolled into one.
Often times, the accelerated cash flow that results from factoring is the catalyst that helps propel companies to the next stage of growth or success. Factoring services can also be used by business owners who are planning their exit strategy as a vehicle to strengthen their balance sheet in preparation to sell the business or attract new partners.
