All businesses need capital to operate. But just as there are endless types of businesses, there are also several forms of funding to keep companies running. Creating cash flow can be achieved through loans, lines of credit, and factoring.
Selling at a Discount
Factoring allows a business to take an accounts receivable invoice and sell it to a third party at a discount. The third party provides the determined discounted value of the invoice up-front to the business then collects on the payments from account debtor (the person or business that owes the money on the invoice). Basically, the business is transferring ownership of the accounts receivable to the third party funding source. The third party that provides the factoring has to wait for the invoice to be due in order to collect the money owed; therefore, the third party might not see a return on factoring for an extended period of time (up to sixty days or more).
The Importance of Aging
Before the factoring deal is settled, the third party funding source will request an accounts receivable aging report. This report will demonstrate the length of time a receivable is owed from the time of billing to the time of payment. If the accounts receivable aging report shows a consider lag period between invoices being issued and invoices being paid, the third party might determine the factoring deal to be too risky. The limited cash flow might be a warning sign of the business’ poor financial health.
Despite accounts receivable aging issues, factoring remains a promising cash flow option to businesses, and the approval process is not based on the business, but the payment ability of the account debtor. The third party will evaluate the credit worthiness of the account debtor and verify the invoice with the account debtor.
The final determination for a factoring deal is based on recourse. Recourse factoring means that if an account debtor does not pay the account receivable invoice, the business is responsible to pay the balance to the third party. Non-recourse factoring means that if the account debtor defaults, the business is not responsible for repayment, and the factoring third party is at a loss.
Even though factoring is an expensive form of financing, it is highly beneficial to a business experiencing rapid growth and need for cash flow. The risk for the business seeking financing through factoring is low, and the ability to capitalize on assets like accounts receivable gives the business a quick way to find capital. Factoring is a controversial though effective financing source, and one that businesses should consider when seeking capital.