All businesses can run into liquidity problems at one time or another. This is especially true for growing businesses, manufacturing businesses and businesses whose customers pay their invoices late. Is there a solution? Invoice factoring is an effective way to improve your cash flow for the long haul.
Invoice factoring is a process where you assign your pending customer invoices to a bank or factoring company in exchange for immediate payment. In other words, the bank or factoring company covers your accounts receivable up front, giving you access to your sales revenue much faster than if you had waited for your customers to pay. Of course, this service comes at a cost, which can vary by financial institution and factoring company.
Are you a business owner looking to improve your accounting procedures and increase your working capital? Invoice factoring might be a good option.
Invoice factoring is first and foremost a short-term financing vehicle businesses can use on a one-time or recurring basis. It is a financing option that companies can use to supplement other traditional means of financing. For example, they can use it to replace a line of credit to quickly monetize their accounts receivable.
Invoice factoring combines three related services:
Although invoice factoring was once associated with unsound or struggling companies, it is now widely used by companies of all sizes in a number of countries and business sectors.
Good to know: Invoice factoring is only an option if all your customers are businesses, as invoices billed to individuals are not eligible for this service.
Invoice factoring comes in many shapes and sizes. Here are the most common practices in Canada:
This is the most common form of factoring. It covers all the bases: rapid financing of cash flow needs, outsourcing of accounts receivable management and protection against the risk of non-payment. Customers are notified that their invoices have been assigned to a factoring company or a financial institution offering this service, and that’s who they need to pay directly once their invoices come due.
With this method, the factoring company finances the invoices, but the customers are not informed of the factoring contract so they still pay the supplier directly.
Reverse factoring is where supplier (and non-customer) invoices are paid directly by the factoring company.
This solution offers a commercial advantage, since suppliers do not have to wait until the actual invoice due date to get paid.
Factoring is available to businesses of all sizes. To qualify, your company’s credit score will be evaluated.
Financing provided by factoring companies is based on the monthly volume of accounts receivable to be financed. The minimum volume required varies from one lender to the next. For example, it is possible to get this kind of financing for less than $10,000 in accounts receivable per month.
Good to know: Invoices for customers in the U.S. or other countries qualify for financing with most factoring companies.
Invoice factoring may be a good fit depending on your business situation.
Differences in customer and supplier terms of payment
In some industries, such as manufacturing, customers may need more time to pay, while suppliers require prompt payment. This lag can have a big impact on the company’s cash flow, i.e., all of its liquid assets.
Factoring allows for better alignment of the timing of cash inflows and outflows. This is known as supply chain financing and it covers the entire process (the entire chain) from the initial supplier to the end customer.
Strong sales growth
To honour new service contracts or maintain production for future demand, a growing business has to spend money up front (hiring, purchasing equipment and raw materials, paying subcontractors) while its customers pay later.
The faster a business grows, the more working capital it needs. Factoring can give it the necessary breathing room to achieve that growth.
Competitive advantage through more flexible payment terms
In a highly competitive market, a company can strive to set itself apart by offering customers particularly attractive payment terms. If the company does not have the cash flow to do so, factoring can provide the financial flexibility to accept longer payment terms.
If a manufacturer or distributor makes most of its sales in the span of a few months, it often has to manage a large inventory for the rest of the year since it cannot produce or procure all its products just before selling them. Storage costs can be significant.
By using invoice factoring, the company will be less dependent on customer payment timelines. This allows it to offer customers longer payment terms to encourage them to buy sooner and thus reduce the volume of inventory to be managed in off-peak periods.
Supplier payment discounts
Some big suppliers may offer especially attractive discounts for prompt payment, but the company does not benefit from this because its customers do not pay as quickly. By monetizing accounts receivable to improve a company’s cash flow, factoring can allow it to pay certain suppliers faster and take advantage of such discounts.
Protected financial ratios
Unlike a loan or line of credit, the amount received in exchange for receivables assigned to the factoring company cannot be considered debt by the company, but rather a “deconsolidating” program. That way, the use of factoring does not adversely affect the company’s financial structure so it is not at risk of falling short on some of the financial ratios it must maintain.
Companies undergoing restructuring
When a company has to make big changes to its operating structure (e.g., in response to an external shock or after an acquisition), the company can easily lose control of its liquidity, because it has to stay on top of uncharted situations as well as day-to-day operations.
In such situations, factoring can help stabilize cash flow. This allows the company’s finance department to focus on restructuring without the distractions caused by short-term liquidity issues.
Accounts receivable requiring extensive management
Another way to look at factoring is as a tool for outsourcing management of accounts receivable. In a time of labour shortages, it may be worthwhile to outsource accounts receivable management to redeploy talent to other company operations. This can help boost efficiency and provide a competitive edge. Factoring is a way to outsource management work to a specialized supplier.
Sales in foreign currencies
When a company issues an invoice in a foreign currency, it takes on a risk of the currency fluctuating against the Canadian dollar between the time of invoicing and payment. If the exchange rate drops during that period, the company will receive less than it expected. Factoring partially counters this risk by providing prompt payment in Canadian dollars, thereby decreasing the window for possible exchange rate fluctuations.
Factoring alone does not solve all cash flow problems. For a company to use it, its customers must be creditworthy. It must also weigh the cost of factoring against the financial benefits it provides. Factoring has become increasingly popular and is getting closer to the cost of a business line of credit.
For many businesses, selling invoices to a bank or factoring company can be a useful tool to round out other financing options. Often, factoring can even play a strategic role and facilitate the company’s day-to-day operations, improve its customer offering and maybe even make it more profitable in the long term.
Want to learn more about factoring services? We’re here to answer your questions.
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