Companies experience cash flow problems at one point or another. These issues are common in small companies and in companies that are growing quickly. Cash flow problems can usually be fixed using the correct type of financing. However, getting a bank loan or a line of credit remains out of reach for many small and midsize businesses.
This article discusses how companies can improve their cash flow by selling their invoices. The article covers:
- Common cash flow problems
- Can you sell accounts receivable?
- How to sell receivables
- 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 factoring company. This financing tool, known as accounts receivable factoring, operates much like a line of credit backed by receivables. However, accounts receivable factoring is easier to obtain than conventional financing.
Most factoring 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 factoring company buys only the financial rights to the invoice. Your company remains responsible for servicing the client. To learn more, read “What is Accounts Receivable Factoring?”
3. How to sell receivables
The process of selling your receivables 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 factoring company performs its due diligence. At this time, the factoring company reviews basic details of your company. This effort includes verifying that:
- The business is properly incorporated
- Your customers have good commercial credit
- A/R is not pledged as collateral
- There are no major legal/tax issues
The application and due diligence step is performed only once, at the beginning of the factoring relationship. Due diligence can be done in a day or two, especially if the transaction is simple. If the process is successful, the factor and client sign a contract.
The next step is to set up your account for financing. The factor 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 factor.
c) Selling the receivables (1st installment)
Factoring 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 factoring is relatively simple. Accounts receivable are usually purchased in two installments. The first installment, 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 Schedule of Accounts
- Factor verifies the invoices
- Factoring company deposits the advance to your bank account
d) Transaction settlement (2nd installment)
The second installment is paid once your end customer pays the invoice in full. Factoring companies often follow this process:
- Factoring company receives payment (via ACH or lockbox)
- First advance and fees are subtracted
- Second installment is deposited in the account
To learn more about factoring, please read “How Does Factoring Work?”
The factoring rate is determined by the risk profile of the account, the amount of financing you need, and the credit quality of the invoices. Average rates range from 1.15% to 3.5% per 30 days and can be pro-rated to account for shorter or longer invoice payment periods. To learn more, read “What is the Cost of Factoring Receivables?”
5. Advantages and disadvantages
Factoring 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 equity
- Relatively easy to get
- Can be used as a temporary solution
However, companies should keep in mind that factoring 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 Factoring Invoices.”
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
Factoring 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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