Cash flow is the lifeblood of any business, and when it slows or stops altogether, it can send a business into cardiac arrest.
All businesses, especially smaller, fledgling businesses, need a reliable source that can provide a quick cash infusion when needed. Not a month from now, but at the time it’s required to pay bills or employees, purchase inventory, or take advantage of a new opportunity.
For hundreds of years, businesses have turned to factors as a quick and reliable source by turning invoices or receivables into cash.
Today, factoring, or receivables financing, is becoming even more popular as a funding alternative – due to the growth of new businesses. However, as quick and easy as it is, factoring invoices may not be right for everyone.
Here’s how to decide if invoice factoring is a good fit for your business.
Invoice factoring is when a business sells their invoices to a factoring company (aka an external financing company).
When a smaller, growing business needs capital, it has limited options for obtaining it. In most cases, banks won’t lend money to businesses without good credit or a lengthy operating history. Investors aren’t likely to invest in a business with spotty cash flows. Oftentimes, family or friends are reluctant to loan or invest money more than once or twice.
However, many businesses do have an asset they can sell for immediate cash – their invoices. Factoring companies will purchase your invoices in exchange for cash upfront, typically up to 90 percent of the invoice amount.
When the invoiced customer pays the invoice in full, the factoring company then remits the balance to the business minus the factoring fee – which ranges from 1 to 5 percent depending on payment terms and other variables.
Some factors charge additional fees for processing and ACH transfers.
With most providers, the factoring process is quick and easy. Once approved for a factoring account, which takes about a day, an invoice can be submitted to the factoring company that then transfers the cash to your bank account within one-to-two business days. Because it is a sale transaction, not a loan, there are no interest charges and the business carries no debt on its balance sheet. When the invoice is paid, the transaction is closed. Additional invoices can be submitted for factoring as needed.
Businesses with poor or no credit are welcomed by factoring companies because it’s the financial stability of their customers that matters most during the approval process. If you have customers with a solid track record of paying their bills on time, you are likely a good candidate for factoring.
Generally, any business that issues invoices to a business customer can be a candidate for factoring. That said, it’s not the cheapest form of financing, and there can be some other drawbacks. However, if your business needs cash now, and you don’t have access to other forms of traditional financing, financing your receivables might be your best option.
Here are some other things to consider to determine if factoring is right for your business.
Factors will only accept invoices issued to other businesses. That’s because they rely on the financial strength and payment history of the business customer to determine if they will be able to collect on the invoice.
They can’t perform the same type of due diligence on an individual customer, and they have more recourse power against a business if it fails to pay the invoice.
The challenge for many small businesses is, to be competitive, they have to offer favorable payment terms, such as 30, 60, or 90 days. For a business relying on every dollar of cash flow to fund its day-to-day operations, that wait can seem like an eternity.
Waiting on payments can cause periodic cash flow shortages, which makes it difficult to take on new or larger orders.
Factoring turns receivables into cash that can be used currently to fund operations while continuing to grow the business.
Once you reach the critical juncture where your excess cash flow can be put in reserve, you won’t need to factor invoices anymore (unless an unexpected expense creates another cash shortage).
Even more established businesses have to contend with cash flow fluctuations when their revenue is seasonal. Factoring invoices is a way to smooth out cash flow to deal with the ebb and flow of seasonal revenue.
When it’s time to bring on more staff or inventory, invoice factoring can keep the cash coming in while you ramp up your business.
If your business has an established credit history, you may be able to obtain more favorable financing by getting a small business loan or line of credit.
Although factoring can be a very expedient way to get cash, it can also be more expensive than traditional financing. However, if you have yet to establish and build business credit, traditional financing may not be an option.
Your goal should be to build a strong credit history so you can eventually partner with a bank.
Factoring can help you do that by enabling you to keep paying your bills on time and help you build a solid record of sound cash management. Remember, factoring does not involve borrowing money, so there will be no indication of it on your credit report.
If your business is less than five years old, you may not have enough of an operating history for banks to gauge your financial stability. Banks want to see a track record of managing cash flow over time to determine if you reliably pay back a loan.
Factoring companies rely more on the financial strength and payment history of your customers, rather than you. In fact, your business can be a new startup and qualify for factoring as long as your customers have an established track record of on-time payments.
More established businesses with a solid history of cash flow management are more likely to be accepted by traditional lenders as viable customers, making them an unlikely or unnecessary fit for factoring.
You may be in the process of building solid credit for your business, and you may have a record of sound cash management, but it’s still possible to be turned down by a traditional lender.
It’s never too early to begin establishing a relationship with a business bank. However, if you can’t afford to wait for a reliable source of capital, you may want to consider establishing a relationship with a factoring company in the meantime.
Invoice factoring is the ideal solution for startups and other businesses that don’t have the credit, financial heft, or assets to borrow against in order to qualify for traditional bank financing.
It could take several years to build the assets and history that banks want to see. Many businesses can’t afford to wait that long, which is why they turn to factoring.
The main criteria for factoring companies when approving invoices for factoring is the financial stability, creditworthiness, and payment history of your business customers.
Their greatest concern is whether your customers can be relied upon to pay their invoices on time. If you have at least one customer that meets those criteria, you can factor an invoice. However, if you don’t have a customer that meets those criteria, you are not likely to be eligible for factoring.
For many small-to-medium-sized businesses, carrying any amount of debt on your balance sheet can hinder the ability to grow profits or obtain future bank financing.
Many business owners do everything they can to avoid carrying debt or consolidate business debts, especially during the early stages of their growth.
Are you reimbursing unauthorized charges? Manage your employee spend with G2 Track.
Factoring is not borrowing – it’s the sale of an asset (your receivables) – so nothing is carried on the books and the transaction is closed out when invoices are paid. More established businesses will sometimes use factoring in order to avoid taking on additional debt.
For any business on a growth trajectory, staying cash flow positive all year round is critical.
Until a business creates its own source through a cash reserve or is financially positioned to obtain financing on favorable terms with a traditional lender, its options are limited or expensive. Factoring offers a reasonably efficient way for businesses to utilize an asset to accelerate their cash flow.
If your business meets any or all of the criteria discussed here, factoring could be a great option as a go-to source of immediate capital.
If you think you may be a candidate for factoring or have a need for it in the future, don’t wait to establish a factoring account. A good factoring company can be a major contributor to your success, and carefully evaluating all your options is critical to making sure you find the right partner for your business.
Discover the highest-rated cash flow management software to help better manage your business finances today.
Grey Idol manages content and digital marketing initiatives for
Subscribe to keep your fingers on the tech pulse.