From time to time, nearly every business experiences cash shortfalls due to the timing of cash payments vs. receipts.Why do shortfalls happen? It all goes back to the cash conversion cycle. Most businesses pay workers on a weekly or biweekly basis. They also try to pay suppliers and vendors in accordance with the negotiated payment terms (typically net 30 days). Some might even pay creditors early to take advantage of early payment discounts. These payments, along with any loan payments, drain cash from the business's bank accounts.
Meanwhile, it takes time for the business to invoice customers and then collect what's outstanding. The end result is often a cash crunch, especially during seasonal peaks when cash outflows temporarily outpace cash inflows.
Factoring to the Rescue
While it's not always possible to slow payments to creditors, business owners can generate much-needed cash by selling the rights to collect the firm's accounts receivables to a third party. Selling accounts receivable balances, also known as factoring, generates immediate cash in exchange for fees paid to the factoring firm.
Here's how it usually works:
Think factoring might work for your business? Here are some important questions to ask before you hand over your receivables to a third party.
With a nonrecourse factoring arrangement, the risk of a customer defaulting generally transfers to the factoring company and, in most circumstances, doesn't come back to your business. However, there may be exceptions where the factor would require your business to buy back the receivable.
Ask each factoring firm you consider for a detailed breakdown of fees they charge. Create a simple spreadsheet for each firm's fee structure. Be sure to ask if they require a monthly minimum transaction. Factoring less than the monthly minimum generates additional fees to maintain the financing relationship. Also search for online reviews and ratings for each firm. Pay close attention to reports regarding delays, excessive fees and an inability to collect on reserves. These all point to operational challenges and reasons to avoid that firm.
Pick a Winner
A number of factoring firms exist, so take the time to evaluate which one best suits your needs. And remember, while factoring your accounts receivables can provide access to cash, it's just one of many ways your business can improve its cash flow. Consult with your financial advisors to devise the optimal cash flow strategy for your situation.