For businesses looking for a quick cash infusion, accounts receivable factoring may be an ideal solution. However, there is a popular misconception that may be preventing many businesses from considering it as a financing option, which is when you are factoring accounts receivable, you are taking out a loan.
The bottom line is that it’s not a loan. It’s actually a sale transaction.
Here’s How It Works:
A business sells its outstanding receivables, or invoices, to a factoring company in exchange for cash. No borrowing. No ongoing interest charges. Just a straightforward transaction that puts your money to work for you more quickly.
With that out of the way, it might be helpful to understand the differences between taking out a business loan and factoring accounts receivable and their impact on your business.
Accessing Capital through a Bank Loan
When you borrow from a bank, you are essentially using other people’s money to finance your business, for which you pay interest. For that reason, the bank has you go through an extensive process to determine whether your business has the capacity to repay the loan on time. If your business has a solid credit history, you may qualify for a loan with favorable terms and a low rate of interest. The one advantage of financing through a bank is it can be the least expensive form of borrowing.
However, if your business credit is subpar, you may not qualify for a loan or, at best, qualify for a loan with less favorable terms and a higher rate of interest. That can be costly over a 24- or 36-month term.
Also, when you take out a loan, your business has to carry it on the books as debt and the ongoing interest charges can eat into your cash flow. That could make it difficult to go back to the bank and borrow more money if you need it.
Accessing Capital through Accounts Receivable Factoring
When factoring accounts receivable, you are not using other people’s money. In essence, you are using your own money already owed to you by your customers. Here’s out it works:
- The business generates an invoice for a customer
- A copy of the invoice is sent to the factoring company which reviews it
- If the invoiced customer meets its criteria as a financially sound company that reliably pays its bills, the factoring company transfers up to 90% of the invoice value to the business.
- The factoring company follows up with the customer for payment and, when it is received in full, the remaining 10% of the invoice value is transferred to the business less a one-time factoring fee.
All of this can happen within a span of two to three days for a new factoring account or in as little as a few hours for an established factoring account.
Also, there’s no long application or credit approval process for the business because the factoring company relies on the financial strength of the business’s customers.
While factoring accounts receivable can be a more expensive form of financing – factoring fees can range between 1% and 3% per month, you can control your costs by submitting invoices only when the need for cash arises. Because you don’t have to wait 30 to 90 days to receive your money, you can put it to work immediately in your business, which can at least partially offset the cost of factoring.
How to Know Which is Best for Your Business
All growing businesses are susceptible to temporary cash crunches, but not all businesses can qualify for favorable bank loans. As your business grows and generates more sustainable cash flow and profits, it will be in a better position to take advantage of lower-cost bank financing. At that point, you’ll probably have the need for additional working capital to expand and that’s when bank financing is your best option.
Until then, businesses need to be nimble and flexible in being able to meet their cash needs, which is why factoring accounts receivable is typically the best option. However, as with any business decision, it is important to do your due diligence to ensure you are partnering with the right factoring company – one that doesn’t overcharge you with hidden fees, and one that will represent you well with your customers. The right factoring company can be an invaluable partner in your success.
You may not have considered accounts receivable factoring, perhaps because of some of the misconceptions surrounding it. But, since you’re here reading this, we invite you to learn more and see how it can address your short-term cash needs. You can get more information and a quote by going to our complete invoice factoring guide, or simply requesting a free quote.