We can’t emphasize this enough: cash flow is the lifeblood of any business. A shortage can occur due to a liquidity crisis or a sales shortfall. For a relatively new business, this can be a big obstacle to growth. You could always apply for a bank loan, but what if we told you that there’s a better way? When you’re in immediate need of cash, whether for expansion or working capital, accounts receivable (AR) factoring can come to your aid. But you need to know the advantages and factors to consider as leverage.
Factoring: A Better Alternative to Bank Loans
Finding the right type of financing is difficult for any business, especially small ones. Your company’s relatively low revenue makes it hard to impress the larger financial institutions because bigger accounts generate higher lending fees. As if that wasn’t enough, these financing organizations often have their own set of rules for most applications.
For example, to qualify for a loan, a small business must provide:
- Full financial reports and copies of relevant records.
- A record of their profitability for at least two to three years.
- Listing of assets, such as accounts receivables, equipment, buildings and sometimes inventory.
As most small businesses operate informally, they can’t always comply with these rules. AR factoring, therefore, is a popular alternative to bank loans when you’re running a startup. It can help your small business with any working capital problems and unlock your customer value and the accounts receivable you’ve earned but not yet collected.
So, before we get into the details of how accounts receivable factoring can boost your company’s cash flow and growth, let’s see how it functions.
What Is Accounts Receivable Factoring?
Accounts receivable factoring is a financial arrangement through which you can stabilize and enhance cash flow in a B2B company. Businesses must usually wait 30-90 days before their customers pay their invoices. But with the help of accounts receivable factoring, you can make sure that you receive payment for your completed work and/or services without delay after the invoice is submitted. The accounts receivable lender, also known as the factor, is the third party that helps you with the process.
Traditional bank lenders rely on a history of profitability and balance sheet strength before granting a loan to a business. A factor, however, focuses more on the credit quality of your customers and not on financial covenants. This grants your company huge flexibility in its cash flow and can be a great help in evolving your business.
The entire procedure happens in two ways:
- The factor lends money against your business’s accounts receivable;
- It purchases your accounts receivable and gives cash based on the unpaid invoices.
You don’t need to worry about billing and credit checking because the factoring firm handles collections. Using factors can also sometimes help make your international business efforts easier, as they sometimes have extensive experience dealing with overseas suppliers.
How AR Factoring Works
AR factoring is quite simple. You usually get almost 70% to 90% of the invoice amount when you purchase your accounts receivable. Your cash flow isn’t damaged and you can continue the regular processes of your business.
The factoring firm then receives the payment from your customers and sends you the balance of the holdback after deducting the cost of their services. In this regard, outsourcing your accounts receivable service is a good idea.
Boosting Your Cash Flow with Factoring
The reason big businesses continue to rule the market is that cash is king. Small and medium-sized businesses often suffer from a cash flow shortage. What’s worse is that when your normal business cycle is disturbed, a cash crunch can become magnified.
Effective Working Capital
Working capital is a business’s available operating liquidity. And your accounts receivable financing can be the most effective type of working capital when:
- Your startup doesn’t qualify for conventional bank loans.
- You need funds quicker for growth and expansion.
- You need to manage a challenging transition.
- You have to constantly negotiate with customers and suppliers to fill the gaps in your company’s cash flow.
- You’re facing seasonal demands.
A Few Points to Consider
Before you opt for the benefits of AR factoring, some things need to be cleared up.
- Shattering the Myths
Some business owners think their AR facility notifies them when the factor receives the receivables, so to speak, from your customers. But customers aren’t paying you directly; they’re paying the firm acting on your behalf.
Others think that availing themselves of this service indicates that their company is weak financially when in reality it can be a great business tool. The best way to shatter this myth is to communicate the value of your company to your customer base.
- Truth About Expenses
This process does come at a cost. Factoring expenses include the factor’s fees which are a percentage of the combined amount of the receivables and certain interest on the capital advance. However, the fees and interest are only applicable for the time that the invoices remain unpaid, making it easy to calculate and use the funds.
- Enhanced Decision-Making
Your factor can put limitations on your ability to do business with a customer depending on their credit history. In these cases, the factor can make your receivables ineligible. However, you can still decide whether to work with that customer.
The positive point is that with the help of someone qualifying your customers’ credit you get a better insight into whether to allow a customer to pay on terms.
- Choosing the Right Factor
Lastly, you must remember that not all factors are compatible with all B2B businesses, and some may only have a narrow niche. So, before you make your approach, choose your lender wisely. Also, read the terms of your contract, conditions and pricing before coming to a decision.
Now that you understand how accounts receivable factoring works to boost business growth and cash flow, you can use it for your organization. You no longer have to spend time on customer credit and collections and can focus instead on more important aspects of your business, like growing sales and building relationships.