Companies experience cash flow problems at one point or another. These issues are common in small businesses and companies growing quickly. Cash flow problems can usually be fixed using the correct type of financing. However, getting a business loan or a line of credit remains out of reach for many small and midsize businesses.
This article discusses how businesses can improve their cash flow by selling their invoices. The article covers:
- Common cash flow problems
- Can you sell accounts receivable?
- How to sell accounts receivable
- Financing costs
- Advantages and disadvantages
- Can this solution help your business?
1. Common cash flow problems
Companies that sell products and services to other businesses usually have to offer net-30 payment terms to their clients. These terms give clients up to 30 days to pay an invoice.
Offering business terms is a common practice that small businesses have to follow. Unfortunately, larger clients demand payment terms as a condition of doing business with them.
Offering terms can create financial problems for companies with low cash reserves or that are growing quickly. These companies can’t wait 30 to 60 days for payment and need funds to pay salaries, vendors, and other critical expenses.
Companies often try to solve this problem internally by offering clients a discount if they pay early. These agreements are simple and fairly effective. Your company offers a discount – usually 2% – to clients willing to pay in ten days or less.
Early payment discounts are a good starting point, but they have some limitations. These discounts are optional, and your client can choose to pay early and take the discount or pay their regular price on their usual schedule.
This alternative is practical if the cash flow needs are minor. In most cases, companies will need to establish a more predictable source of cash flow. You can accomplish this by selling your receivables.
2. Can you sell accounts receivable?
Companies can improve their cash flow by selling their accounts receivable to a specialised finance company. This financing tool, known as invoice financing, has similarities to a line of credit backed by receivables. However, invoice financing is easier to obtain than conventional financing.
Most invoice financing transactions are structured as the sale of an asset rather than as a loan. Your company sells the financial rights to specific invoices in exchange for immediate payment.
Note that the finance company buys only the financial rights to the invoice. Your company remains responsible for servicing the client. To learn more, read “What is invoice financing?”
3. How to sell accounts receivable
The process of selling your invoices consists of four parts. The process is relatively simple, and the first invoice can usually be purchased in a few days. Subsequent purchases from approved customers are made as needed, and those invoices are usually purchased in a day.
a) Application and due diligence
The first step is to submit an application so that the finance company performs its due diligence. At this time, the finance company will review your company’s basic details. This effort includes verifying that:
- Your company has an ABN or ACN
- Your customers have good commercial credit
- A/R is not pledged as security
- There are no major problems
The application and due diligence step is performed only once, at the beginning of the financing relationship. Due diligence can be done in a few days, especially if the transaction is simple. If the process is successful, the finance company and client sign a contract.
b) Setup
The next step is to set up your account for financing. The finance company sends a Notice of Assignment (NOA) to your clients whose invoices you want to finance. The NOA is a standard document in the industry. Once the setup process is complete, your company can begin to sell invoices to the finance company.
c) Selling the receivables (1st instalment)
Invoice finance lines are designed to work as a revolving line of financing. Once your account is set up, you can sell invoices from approved companies as needed. The purchase and sale process in this transaction is relatively simple.
Accounts receivable are usually purchased in two instalments. The first instalment, called the advance, is deposited at the time of the purchase. The second deposit, described in step d, is the settlement. Factors usually advance funds by following these steps:
- Client submits invoices and a list of accounts (or a ledger)
- Finance company verifies the invoices
- Finance company deposits the advance to your bank account
d) Transaction settlement (2nd instalment)
The second instalment is paid once your end customer pays the invoice in full. Finance companies often follow this process:
- Finance company receives payment
- First advance and fees are subtracted
- Second instalment is deposited in the account
To learn more about factoring, please read “How Does Invoice Finance Work?“
4. Costs
The financing rates are determined by the risk profile of the account, the amount of financing you need, and the credit quality of the invoices. Most invoice finance companies charge an administration fee and an interest rate.
The administration fee is based on the value of the invoice, while the interest rate is applied only to the advanced funds. To learn more and see a detailed example, read “What is the Cost of Financing Invoices?”
5. Advantages and disadvantages
Invoice finance provides a number of advantages for small and midsize business owners. These include:
- Improves cash flow quickly
- Available to small businesses
- Does not require you to give up ownership
- Relatively easy to get
- Can be used as a temporary solution
However, companies should keep in mind that invoice finance can be expensive relative to other solutions. It should be used only by companies whose profit margins are higher than 15% and whose invoices pay in 30 to 60 days. To learn more, read “Pros and Cons of Invoice Finance.”
6. Can this solution help your company?
Accounts receivable financing is an effective solution to improve cash flow as long as it is used in the right circumstances. This financing helps your company if:
- It has cash flow problems
- Cash flow problems are caused by slow-paying clients
- Your clients have good commercial credit
- Your profit margins support financing
Invoice finance does not help your company if its cash flow problems are caused by declining sales or other problems. Lastly, it does not help your company if your profit margins are low.
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