Often times a small business that has cash flow needs will use a process that is called factoring receivables.Â This is basically a fancy word for selling your receivables to someone else for cash up front, and then the purchaser is the one who collects from your customers.
How Factoring Receivables Works
When a company decides to factor their receivables typically they will sell their receivables to a company for eighty to ninety percent of their value.Â The purchaser then collects these receivables on the companyâs behalf.Â Once the receivables are all collected (less those that will be considered bad debt), the purchaser will remit to the seller the difference in the face value of the receivables less what was advanced.Â
They will also subtract from this amount typically one to three percent of the total face value of the receivables that they either collected or attempted to collect.Â This amount is basically the finance charge for using their money before your customers paid.
Is Factoring Receivables Right for Our Company?
The basic answer to this question would be that is should not usually be done.Â When you take into consideration that you are paying one to three percent interest each month that can equate to twelve to thirty-six percent per year.Â That is a steep price to pay in order to have cash in what is typically thirty days in advance.
The company would be better off taking a line of credit from their local bank for a lower interest rate rather than factoring their receivables.Â This would be a lot cheaper alternative for the companyÂ in the long run.
However if you are a small company with limited, poor, or no credit, and are in a cash crunch, it may be one of the only options you have available to you.Â Often times small companies are not established or may have shaky credit buy may need a one time cash injection to finish a project that may help them grow revenues and profits for the future.
As long as factoring receivables is used in this fashion it could possibly be considered acceptable.Â The company needs to make sure it does not become a crutch in which they rely on the factoring of receivables in order to stay afloat every month.Â The company should be building their business on a foundation of a solid balance sheet where they do not have the need to factor receivables.
In the end, it would be best for most companies to stay away from factoring receivables unless it was a true emergency.