The success of many businesses depends upon how well they can manage working capital. Good working capital management ensures that small businesses can meet their routine operational expenses and manage debt. At the same time, businesses with a long account receivables cycle certainly find that managing working capital presents a challenge. Many companies turn to small business factoring as an effective solution to get paid faster.
How Small Business Factoring Helps Manage Working Capital
Actually, small business factoring is a very traditional kind of business financing. Basically, it works like this:
- One company sells the right to collect upon accounts receivable to another company.
- The company sells this right at a discount, typically two to six percent of the total.
- The seller may collect about 75 percent of the value of the receivables immediately.
- After the purchaser collects, they might pay the remainder of what they owe.
What is the advantage of factoring for small businesses?
Basic business classes teach that money always has a time value associated with it. To a small business that has to pay employees and suppliers, having the working capital to meet expenses provides that value. The company waits to collect the rest of the sales price of their accounts receivables, but at least the business owner can count on getting most of their money right away. For companies that have to wait a long time between investing in sales and getting paid, business factoring is one tool that can keep them afloat.
Why do factoring companies buy accounts receivables?
Since the factoring companies get to purchase these accounts at a discount, they profit when they collect. For example, the purchaser might collect $100 for every $94 they spend. They look at this difference between what they pay and what they collect as a return on their investment.
3 Times Small Business Factoring Can Benefit a Business
When should small businesses consider factoring their receivables? Here are three instances when it can be beneficial:
- Companies that can’t manage their working capital without getting paid faster might benefit from selling their accounts in order to get paid quickly.
- Some businesses may need to get paid faster in order to take advantage of a chance to grow their business.
- Since factoring deals are not loans, this type of business arrangement might really help companies that can’t or don’t wish to assume debt.
Are There Disadvantages of Business Factoring?
Certainly, companies do have to accept one large disadvantage when they choose factoring as a way to finance their business. They must sell their accounts receivables at a discount, so they won’t receive the full value of their payments or profits. To understand this, consider an example:
- A company that sells $100,000 of accounts receivables may only get $94,000 back.
- In this example, the company could collect $75,000 right away.
- They collect the rest of the $19,000 when and if the buyer collects on the invoices.
- The sale price will never amount to the total value of the invoices.
Depending upon the time that the company expects to get paid by their customers, this could work out to a fairly large price to pay in order to get money faster. For example, some seasonal companies might only need help with working capital for a few months. If a small business has to give up a percentage of payments, they are also losing profits. Also, the business loses control over collections, and they have to depend upon their buyer to collect in order to get paid what they are owed.
A Working Capital Loan Might Offer a Better Alternative to Business Factoring
A working capital loan might offer a cheaper and better solution for some small businesses. Companies that just need short-term advances on their future receivables may find that they will pay less for a working capital loan than they would have lost by arranging a deal to factor their invoices.
Can small businesses qualify for working capital loans? Some business owners might not have had a chance to build credit for their business. However, it’s very possible to find lenders who do not look at traditional credit scores when they consider borrowers. This is particularly true for online lenders because they have the ability to consider a great number of different factors that a business may have in its favor.
Instead, online lenders can look at the same thing that factoring companies look at—that is, they can base working capital loans upon the value of accounts receivables. Very often, if a small business has the invoices to arrange a factoring deal, they also have the ability to qualify for a working capital loan.
Working Capital Loans vs. Small Business Factoring
Small business factoring deals have been around for a long time. The biggest advantages include the ability to collect upon invoices quickly and not to have to bother with payment collection. In some cases, business owners might prefer to refrain from taking on debt. In other cases, the business owner might believe that the company would not qualify for a loan. Some small businesses have relied upon factoring for financing for a long time, so management might not have even considered any alternatives.
On the other hand, working capital loans can present a cheaper and more convenient solution. Because it’s possible to obtain a line of credit, the business can also choose to only draw the funds they need. That means the company only has to pay interest on the money they take and not always the entire amount of the loan. They also have some control over how long they will take to pay back the loan. This makes working capital loans a very flexible and convenient solution.
In any case, it’s important to understand that working capital loans could offer a good alternative to small business factoring. It might pay to consider both options to see which one would really benefit your business better.
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