Can Your Business Benefit Using Invoice Factoring?
This blog post will explores in detail whether factoring can work for you. It will also compare factoring with other means of finance.
It is a fact that factoring works for many businesses across many industries. However, it may not work for everyone. For companies that get their payments in full, via cash or credit card, and do not want to extend credit terms to their customers, factoring may not be viable.
For businesses that sell directly to consumers, the traditional factor might not work. However, there are finance companies that offer financial assistance to such companies based on their credit card sales.
Factoring is such is a simple process, compared with traditional financing procedures. You can qualify to use factoring to boost cash flow if you answer ‘yes’ to the following two questions:
- Do you issue invoices to creditworthy customers?
- Do you wait between a couple of weeks to two months?
This is the basic requirement that a factor looks for before working with the business. Apart from this, the factor may have other eligibility criteria, depending on the factor. Some factors cater to specific niches, while others look for invoice volumes.
So are YOU a good candidate for factoring? Apart from the two questions to which you answered in the affirmative, look at the following statements. If these apply to your business, then factoring could work for you:
- You need finance for operating expenses
- You have a growing business
- Your business is less than three years old
- Your business sells to established customers
- Even though your credit rating is not good, your customers are creditworthy
- You often face a cash crunch when it comes to paying for raw materials, payroll expenses, etc.
- You are forced to lose business because you are unable to offer credit terms to customers
- You could do with extra working capital
- You are unable to keep up with timely bill payments due to cash flow problems, resulting in poor credit rating
- If you had cash, you would take advantage of discounts
- You could focus on business if your invoices could be managed
If you can identify with all the statements above, then you cannot afford to ignore factoring.
Now let us compare factoring to the conventional financing options.
When there is a need for finance, businesses generally dip into their own funds. Next, they consider private investors, followed by bank loans, and venture capital. Here is a look at each, in turn, vis-à-vis factoring.
Private Investors vs. Factoring
At the early stages, the business owner will dip into his personal savings and perhaps try to borrow from friends, relatives, and others who are ready to lend or invest. At times, the owner might also have to relinquish equity to private investors in the business in order to raise funds. As this money also runs out, he might end up gradually losing his share of the business. Debts might build up, along with differences of opinion on operational issues between the owner and investors.
Companies that are trying to survive are perfect candidates for factoring, especially those poised for growth. Because of the way factoring works, the factor and the business grow together, mutually benefiting from the increased volume of accounts receivables. There is no question of losing ownership at any stage.
As a company grows, private investors could be hard to find. With factoring, if the factor is too small to handle the growing business, the services of a larger factor can always be sought. There is also the chance that the growing business’ cash flow may stabilize to such an extent that they may no longer need factoring. At this stage, banks may be ready to sanction loans because of the business’ good financial standing. However, many businesses prefer to use factoring because of its other advantages. Their factor handles other services like managing accounts receivables, billing, collection, and credit screening, so it is not surprising that a business would always turn to factoring in a cash crisis.
Bank Loans vs. Factoring
There are different aspects of a bank loan. A lengthy and complex process, it begins with the application and supporting documents where you have to produce tax and finance statements from, at least, three consecutive years. For new businesses, bank loans are not even an option, as they obviously cannot produce these documents. Banks also expect the business to be their customer for some time and use various banking products before they can even apply. This allows the banks to monitor their spending habits and decide whether they can approve the loan. Being a customer of the bank, however, does not guarantee a loan approval, as most of you will already know.
In contrast, with factoring, small business are not expected to produce any documented proof of their financial standing. Larger factors might ask for a business plan from companies that have large invoice values. A contract is, of course, mandatory to process the factoring. In any case, the paperwork is a lot less complex than with bank loans.
In cases where the business requires more funds, with banks, an application for a fresh loan is required and will involve the same procedure. In factoring, when more funds are needed, the only documentation required is more invoices. After the initial approval is established, business is ongoing.
If a business has poor credit rating, banks will not even consider granting the loan. It is the same with bankrupt businesses and those with criminal records. While factors do carry out a background check through public records, criminal history, etc., they do not decline bankrupt companies and those with poor credit. The only thing that matters to a factor is the business’ customers’ credit standing. If the business has already declared its receivables as security against a loan, a factor may not accept the application. In the case of tax payment plans, the factor might even assist in coordinating and working out regular payments. In the end, factoring helps a business improve its credit standing. Since there is enough cash to handle all the expenses, it is not surprising to see the business’ credit rating go up.
With bank loans, repayments are made periodically, and are comprised of the principal amount and the interest. This could stretch as long as seven years and the interest rate depend on the business’ credit rating and the prevailing rate.
By nature, factoring is not a loan and, therefore, there are no repayment or interest charges. Depending on the business’ industry, customer creditworthiness, volume of receivables, and terms agreed between the business and customer, discounts can apply, resulting in further savings for the business. Factoring just puts cash control in the business’ hands, where it belongs.
Banks insist on collateral that is of the same or greater value than the loan amount at the time of loan sanction. In the case of defaulting on repayments, this collateral is used. Factors are more flexible with this.
Venture Capital vs. Factoring
When a business considers venture capital investment to raise funds, it must prepare detailed business plans with future projections, market analysis, market strategies, and management biographies. Some businesses spend months preparing these documents. Venture capitalists also expect a chunk of equity from the business they decide to fund, and insist on placing their own employees in key positions.
In factoring, a business plan is not mandatory. In addition, factors are not interested in controlling the business they help with funding.
Equipment Leasing vs. Factoring
Businesses usually go in for equipment leasing when they can’t afford to buy the equipment. This can happen by leasing the equipment through an equipment leasing company that purchases the new equipment, or by selling the existing equipment to a leasing company and then leasing it back from them. Often, factoring can work alongside equipment leasing since both businesses have similar customers who are in need of cash.