As it becomes increasingly difficult, even for reputable companies, to obtain credit by traditional means, more companies are turning to factoring as a way to solve short-term cash-flow problems.
Factoring is a process by which businesses sell their accounts receivable to a factoring company at a portion of their value — typically from 50% to 70% — in order to receive, in a matter of days, money that would typically take up to 60 days or more to collect from vendors.
The factoring company then takes on the responsibility of collecting the money from the vendors. After it is collected, the remaining difference is returned to the business, minus a fee (usually 2% to 6% monthly).
TOO RISKY?
Because it allows companies to obtain cash in just a few days and because it does not require a credit check (factoring companies are only concerned with your vendors’ ability to pay them, not yours), factoring can be a possible solution for companies that are short on cash or are unable to obtain credit.
There are, however, major risks involved with factoring, according to Tom Taulli, author of The Complete M&A Handbook and financial writer for BusinessWeek.com.
“Of all the alternatives out there for small businesses, factoring should be a last resort because the costs are so high,” he says. Over time, fees can exceed 20%, and many companies charge an additional 1/15% to 1/8% for each day after the first 30 days that vendor invoices go unpaid. “This can be rough for a small business with low margins and not much room to maneuver.”
Before jumping in, Taulli recommends talking to several factoring companies to get a real sense of the total cost.
STILL A VIABLE OPTION
Despite its potentially high cost, factoring is still a viable option for companies truly in need. Once a relationship with a factoring company is established, it takes just a couple of days to receive your money. But finding the right company and establishing a relationship can take as long as a month, so plan ahead.
Taulli recommends asking local banks for factoring references, and even notes that some banks offer this service themselves. Established entities such as Liquid Capital are a good place to start, he says, or search online for factoring firms.
If you do decide to work with a factoring company, don’t do it for too long, Taulli warns. “Do it for a month or two. But if you do it every month, the cost really adds up.” Instead, try to find ways to lower costs, and reevaluate your relationships with vendors who are unreliable with their payments.
