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Factoring for small businesses – the pros and cons

November 21, 2013

If you’re doing well enough that your business is growing rapidly you would expect your finances to be healthy. But that isn’t always the case.

If your firm is expanding quickly, you could find that your cash flow becomes a problem, even though your business is profitable.

It’s a unique financial situation where you are selling so much that you can’t get the money in the door fast enough to pay for the raw materials you need for your next batch of products.

It’s a common problem, especially for businesses that issue invoices on 30 day terms and find some clients prefer to extend their terms to 45, 60 days or longer.

Growing businesses can be struck by cash flow problems

As you grow, you have more and more of your money tied up as working capital. The knock-on effect is to cause real cash flow issues.

Without the cash in the bank from previous sales, where are you going to find the money to pay for future supplies? It’s a huge problem, especially if your business is new and therefore can’t get adequate credit terms from suppliers.

There are a number of options available to businesses who want to improve their cash flow position.

One solution to overcome the problem is to take out a loan or overdraft to create more working capital. It can take a little while to arrange a business loan with your bank, so if the cash flow issues are imminent you might not be able to wait.

Another alternative, which can usually be put in place quicker than a loan, is something called ‘factoring’ or ‘invoice finance’. With this option you effectively borrow money against the invoices you have raised.

How factoring works in practice

How it works in practice is that you send a copy of every invoice you issue to your factoring company. It will then “lend” you a percentage of that invoice.

This means that you will receive a chunk of the money as soon as you have issued the invoice and not have to wait until your customer eventually pays you.

With, what is in effect, an advance on your invoices, you are able to immediately re-invest this advance to, supplement your working capital, improve your cash flow and fuel further growth.

The factoring company will pay the balance of the invoice to you, once it has received payment of your invoice from the customer and subtracted its fee.

For example, let’s say you raise an invoice for £3,000. You give this to the factoring company, which straight away gives you 80% of the value of the invoice, in this case £2,400.

30 days later it chases your customer for full payment of the £3,000 invoice. When you customer has paid, you get the remaining £600, minus the factoring company’s fee and interest on the money you have “borrowed”.

Factoring has been around for thousands of years, with some historians tracing it back to the Roman Empire and further. But it isn’t for every business, so ByteStart examines the main advantages and disadvantages of factoring for small businesses;

The benefits of factoring

Positive cash flow

There can surely be no smarter way of keeping a positive cash flow than factoring. The perfect world where customers pay immediately doesn’t exist so this is the next best thing. The money is in your bank account much faster, making it less likely your business will run out of cash while it grows.

Get cash fast

If your business currently has a number of outstanding invoices, a factoring company may be able to pay a high percentage of them to you quickly.

Better financial planning

Because you know exactly when the money will hit your account you can take much more calculated financial risks. You may also find it easier to attract investors and borrow capital as you can prove a regular cash flow.

Have more knowledge about your customers

Many factoring companies insist on credit checking your customers before you offer them credit. This reduces risk for everyone. There’s no point selling something to a customer who doesn’t have the means to pay.

Highly competitive industry

There are a lot of players in the industry, which is great for keeping prices low.

Makes you seem more professional

Some customers may respect a factoring company more than you (!) meaning they may pay more quickly. This could be the case if you use the factoring services offered by the big name banks.

Avoid bad debts

If you enter into something called “non-recourse factoring”, the factoring company is responsible for the debt if it turns bad. Of course this works out more expensive than “recourse factoring” where any debt problem is still yours.

The drawbacks of factoring

Cost of borrowing

Factoring is still a form of borrowing and there’s a cost associated with that. You will pay a fee for every invoice factored, plus interest on the money you have “borrowed”. So slow-paying clients will still cost your business money.

Lose control of how you do business

Your factoring company may demand a say in the kinds of customers you take on (or rather the kinds of risk you take) and how you do business.

You may find your terms & conditions have to be changed, and clients are told how the factoring company likes things to be done.

Lose control of debt management

The factoring company will take responsibility for chasing up outstanding debts. And that means strangers working for another company ringing up your clients and demanding cash!

You may also find that a factoring company will not accept new invoices for some customers while other invoices are still outstanding, even if your business is happy to take the risk of the extra business.

You are still liable for bad debts

With “recourse factoring” the debt problem is still yours. So you will still lose money on clients that don’t pay.

Factoring companies will ask for their advance on the invoice to be returned, often within a fixed period of time. And of course they may take the money from future advances, which will affect your cash flow.

Hard drug to stop taking

The final downside of factoring is the fact it is like a drug. Once your business is reliant on factoring for good cash flow, it will take an injection of capital to wean you off it.

More cash flow and financing help

You can find help and tips on all aspects of business funding on ByteStart. Here are a few of our popular guides to help your cash flow;

And these will help you with other business funding options;