Companies sell their receivables to improve their cash flow. Having good cash flow is essential if you want to run a successful business. You can have a great product/service and excellent profit margins, but your business will suffer if your cash flow is bad. As a matter of fact, profitable companies can also have serious cash flow issues.
Offering net-30 to net-60 sales terms is a common source of cash flow issues, especially if the company is:
- Growing quickly
- Running low on funds
- A brand new startup
- In turnaround mode
Slow-paying customers affect your ability to run your business. They tie up your funds and affect your ability to pay employees, cover supplier expenses, and run the business.
The issue: offering net-30 or net-60 day terms
Offering net-30 or net-60 day terms to clients negatively affects your cash position. It’s a simple matter of timing. Employees and suppliers have to be paid quickly. Offering terms allows you to deliver the product/services to your clients. However, your clients can take up to two months to pay their invoices.
When it comes to offering terms, small businesses can’t do much about it. Clients, especially larger ones, pay their invoices in 30 to 60 days. These terms are in their contracts and are usually non-negotiable. Your clients pay slowly for a simple reason: it helps their cash flow and does not cost them anything.
This situation leaves smaller companies caught in a financial catch-22. You want to take on new sales and grow your business. But to do so, you have to offer payment terms. And if you offer terms, you risk running into financial problems.
One way to solve this problem is to sell your accounts receivable.
Selling receivables improves cash flow
Companies can improve their cash flow by selling their invoices to a factoring company. This sale provides your company with quick access to funds while the factor waits to get paid.
The process of financing receivables is called factoring.
How does factoring work?
Factoring companies usually buy your accounts receivables in two installment payments. The first installment is called the advance and covers about 80% of the value of your invoices. The advance is funded as soon as you submit the invoice.
The remaining 20%, less the factoring fee, is refunded once your customer pays their invoice in full. The second installment settles the transaction. Most companies that use factoring sell all or part of their receivables regularly. Financing receivables ensures they always have cash-on-hand to pay expenses.
To learn more, read “What is factoring?”
Advantages and disadvantages
A factoring solution has a number of advantages and only a few disadvantages. Advantages of factoring include:
1. Bridges cash flow gap
The most significant advantage of a factoring line is that it solves cash flow problems created by slow-paying invoices. It does this effectively and provides a platform for further growth.
2. Helps improve credit of your client base
Factoring companies help you evaluate the commercial creditworthiness of your client base. This helps ensure that you provide terms only to clients with good payment histories.
3. Can be deployed quickly
Lines can be deployed quickly, often within days. This time frame makes factoring lines an excellent solution for situations that require quick action.
Keep in mind that factoring receivables helps only if your financial problems can be solved by getting paid faster. Consequently, their use is limited to certain situations. Factoring does not help if you have other financial problems.
Why not use a line of credit or a bank loan?
In principle, a business line of credit is an ideal solution for cash flow problems. They are flexible, enabling you to draw from the line to pay company expenses and repay once invoices get paid.
However, lines of credit have three drawbacks. Qualifying for a line of credit is difficult due to underwriting requirements. Businesses, and their owners, need collateral and a good track record. This issue rules out most new businesses.
Additionally, the process to get a line of credit can be lengthy. Lenders require substantial documentation and can take weeks to make a decision. Lastly, negotiating a line increase can be difficult, especially if the request comes shortly after getting the line. Lenders require a line to be “seasoned” for some time before considering increasing its limits. The process to increase limits often requires additional underwriting by the lender.
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