Top 10 Myths About Accounts Receivable Financing – Part 1
Accounts receivable financing, or “factoring” as it’s also called, is a form of alternative funding that has been around for decades, yet there are still many misperceptions about what it is and how it works.
Factoring is a way to improve cash flow by receiving an advance on outstanding invoices rather than waiting until they are paid. The factoring company advances up to 90% of the value of the invoice up front and then remits the balance once the invoice is paid.
Many businesses can benefit from factoring, but confusion and misinformation prevent them from exploring this funding option.
Myth #1: Factoring Is a “Last Resort” for Desperate Businesses.
FACT: Businesses that choose factoring are no more “desperate” than businesses that apply for business loans or lines of credit. Many factoring clients are very successful and growing quickly: they choose accounts receivable financing because it is more flexible and accessible than traditional forms of financing.
Examples of businesses that choose to factor their invoices include:
Startups: To qualify for most traditional funding sources, such as business loans and lines of credit, a business must be able to show two years of business history, which can put these funding sources out of reach for young and fast-growing businesses. Accounts receivable financing, on the other hand, focuses on criteria that a thriving startup is more likely to meet, even if they don’t have a lengthy financial track record.
Seasonal and cyclical businesses: Banks look for consistency in the company’s cash flow as an indicator that the company is stable and less of a credit risk, but some businesses are unable to demonstrate the required consistency because of their seasonal or cyclical nature. Revenues for seasonal businesses fluctuate with the weather and time of year, while revenues for cyclical businesses are affected by economic upturns and downturns.
High-growth companies: Businesses that are growing quickly need access to cash to fund their expansion, but many banks see rapid growth as a risk factor. For example, a staffing company that wins a large contract may find that a bank won’t issue a loan or line of credit based on the potential revenue that contract represents, whereas a factoring company will.
Myth #2: Factoring Is for Businesses that Can’t Qualify for a Bank Loan.
FACT: Businesses that qualify for traditional bank loans and lines of credit may still choose factoring as a funding source in order to avoid restrictive terms. Traditional loans can include covenants that require the borrower to fulfill certain conditions or that restrict certain business activities, while factoring gives the business owner the freedom to run their business and make the business decisions however they see fit.
Accounts receivable financing can also release a larger sum of working capital than a bank would be willing to extend because a factor and a bank use different lending criteria. A bank evaluates the business’s own credit-worthiness and the value of its own assets when making a funding decision. A factoring company, however, evaluates the credit-worthiness of the business’s entire customer base and the value of its accounts receivable, which can qualify the business to access more funds than a traditional loan would offer.
Myth #3: Factoring Can Impact Your Customer Relationships Negatively.
FACT: Businesses work hard to build good relationships with their customers, and it’s natural for them to be protective of those relationships. But the truth is that by factoring their invoices, businesses improve their customer relations in several key ways. By factoring their invoices, a business can:
- Focus on the aspects of the customer relationship where they bring the greatest value—delivering great products or services and excellent customer support.
- Put their payment processes in the hands of a team with more experience and a specialized skill set.
- Free up the cash they need to deliver on their promises and demonstrate their trustworthiness.
- Take advantage of third-party collection and credit services that make it easier for customers to find convenient payment options.
Myth #4: Factoring Is an Expensive Way to Improve Cash Flow.
FACT: The cost of accounts receivable financing has decreased steeply over the past two decades. Today, factoring fees are much more in line with those charged by a bank, with some factoring companies offering rates as low as 1% every 30 days.
While these lower rates are still higher than those of a traditional business loan, it’s not an “apples to apples” comparison, because factoring rates cover both funding and a range of valuable and time-saving services.
In addition to converting your outstanding invoices into cash, a factoring company also lightens your administrative load by assuming all the work involved in servicing those invoices, managing the payment process, and vetting customers for credit-worthiness.
And finally, if your business is able to take advantage of early payment discounts with suppliers by factoring your invoices, it could fully offset your factoring costs.
Myth #5: All Factoring Companies Offer the Same Fees and Services.
FACT: Factoring companies offer widely differing fees, services, and contract terms, so it pays to do your research.
Fees: Some factoring companies charge businesses an up-front, non-refundable application fee, while others do not. Service fees can also vary, with some factors charging just $11 for a wire transfer and others charging upwards of $30. It’s a good idea to ask the factoring company to provide a list of all the fees they charge above and beyond the interest rate on the invoices they factor.
Contracts. The length and terms of the factoring contract can vary widely between different factoring companies. Some are very inflexible and require your business to sign a one- or two-year contract during which you must factor all of your invoices. Other factoring companies offer much more flexibility by allowing you to choose which invoices to factor and commit to contracts as short as 90 days.
Services. Some factoring companies are staffed with entry-level employees, while others hire experienced professionals. Because the factoring company will communicate with your customers, it’s important to choose a factor with a documented onboarding process and long-term staff. Make sure to ask the factoring company how many years of experience they require of their staff, how long their staff have been with them, and what their customer onboarding process looks like.
See Beyond the Myths
With access to a wider range of funding resources, your business is better equipped to overcome challenges and become more resilient. By knowing the myths and truths about accounts receivable financing, you can make informed choices about how best to manage your cash flow.
Please tune in next month when we tackle five more myths about accounts receivable financing!