There are trillions of dollars in outstanding trade credit in the US economy today, and at least some of it is undoubtedly causing an unnecessary drain on cash flow for many.klein- forAverage-Sizecompanies (SMEs). Giving customers 30 days to pay has long been common practice in many industries, but since the 2008 financial crisis, many SMEs in the supply chain have faced increasing pressure to extend payment terms. to 45, 60, 90 or even 120 days, which would significantly affect lengthening cash conversion cycles. As trade receivables rise, SMBs must invest more cash in working capital to finance operations, prepare for emergency spending, and position themselves to benefit from the next growth.occasions.
SMEs with significant amounts of receivables can effectively alleviate liquidity problems by factoring these receivables. However, factoring can be an expensive form of financing, and many financial advisors do not recommend it because they believe it is too expensive.
WAS I FACTORING?
While many large and successful companies routinely factor accounts receivable, SMBs may not be familiar with this financing option. In a factoring arrangement, a company sells its accounts receivable to a financial institution (a factor) for cash but at a reduced price. The factor assumes collection duties and typically makes advance payments of 70% to 90% of the claim value and passes the remainder less fees.Collection.
The factoring commission is a small percentage of factored accounts receivable that covers the administration costs of factoring, the costs of collection services, and a financing commission on the amount of money advanced by the factor. Recourse factoring can lower fees as it reduces factor risk. "Recourse" means that part of the cash advances may have to be repaid to the factor if collection efforts are madeSomething bad happened.
Some factors may be unwilling to purchase certain receivables, reducing the value of factoring as exclusions can significantly reduce the resulting cash gains. For example, the factors are often mutually exclusive.low-QualityAccounts receivable by age. Many factors also do not accept claims from exporting companies due to the additional time and expertise required to completecruz-Shouldproceedings. However, for many SMBs, it may be worth investing the time to find the right factor.Ella.
WHO CAN BENEFIT
When a company evaluates factoring as a possible form of financing, individual circumstances must be taken into account. Not all SMEs can benefit from factoring agreements. Some of the characteristics to consider when determining whether to consider selling accounts receivablecontain:
The truth is that factoring is expensive. Conventional loans that are secured by tangible assets, such as inventory, are often a cheaper financing alternative. However, tangible assets are not always available to secure a conventional loan. For example, service providers don't have inventory to back up. In addition, many service companies are notCapital city-intensiveand therefore do not have many fixed assets (PP&E). Even companies with significant fixed assets can lease themasset.
Cash on delivery only
Businesses that don't sell on credit can attract new customers faster by offering them more flexible payment terms, and factoring can allay concerns about the cash flow impact of carrying large receivables. Existing customers can also order in bulk if they don't have to pay cash on delivery, which would offset the cost of factoring by reducing shipping and ordering costs.processing.
Inconsistent payment terms
Companies that offer their customers longer payment terms than they get from their suppliers may find themselves in an ongoing cash crunch. If SMEs routinely try to strategically plan supplier payments to match expected customer payments, this is a good indication that factoring can be useful. Also, if factoring allows SMEs to take advantage of the purchase discounts offered to pay suppliers faster, the costs are offset.factoring.
occupationone more time-repeatCollections personnel are expensive and may only be unnecessary for businesses with many receivables for part of the year. Seasonal businesses can reduce overhead by outsourcing the billing function through factoring. The cost of factoring would be offset by the economics of outsourcing, and factoring experience can significantly increase accounts receivable.turnover.
Growing companies face rising operating costs and require higher investments in working capital. The problem is that while cash outflows for additional staff, inventory, etc. are increased to meet projected sales growth, cash inflows reflect sales levels in recent months. Factoring can alleviate this growing pain by shortening cash conversion times.Cycle.
It is common for new businesses to have negative cash flow from operations. New business not yet profitable or business with highdebts-for-incomethey present a significant risk of default and, as a result, may not qualify for traditional loans or lines of credit sufficient to support operations. In such cases, factoring can be used to reduce the probability of cash shortages, since the ability to finance with accounts receivable does not depend on the creditworthiness of the SME, but on its creditworthiness.Customers.
low quality claims
If an SME's average sales receivable term exceeds the terms of sale, or if the accounts receivable balance is growing faster than sales, this may indicate that the SME does not have the expertise to effectively manage the receivables. credit risk. Although factors generally do not acceptlow-Qualityaccounts receivable, it is never too late for companies with insufficient credit management skills to benefit from a factor's expertise. SMEs can even ensure the acceptability of future demands by implementing aCredit-permissionprocess approved byFactor.
Government contracts usually lead toalternative-QualityAccounts receivable, but even a profitable business will not survive if the cash arrives too late to meet its obligations. Doctors in some states have waited up to a year for insurance payments for government employee health care benefits, but once a factoring agreement is established, the wait can be as short as a few hours.
Not all factors accept the demands of exporters, but those that offer more than liquidity do. They also offer expertise in dealing with foreign clients that a typical SME is unlikely to possess. Foreign languages, accounting standards, business customs, and legal frameworks can be extremely difficult to navigate. Consequently, it can be important to have an experienced factor facilitating transactions around the world.Advantages.
WHO DOES NOT BENEFIT
Some of the business characteristics that suggest factoring may not be suitable for an SME are often only corollaries of those that suggest otherwise. For example, companies with excellent credit management may waste money on factoring. Some additional considerations that may negate the potential cash flow benefits of factoringcontain:
Factoring receivables from paying customers reliably and quickly probably isn't worth it.cost.
KMU after alow-costThe management strategy may not be able to account for and maintain profitability because the margins are too tight. On the other hand, factoring might even make sense.low-costLeader. However, this determination requires a careful analysis of the company's cost structure. Businesses that operate with significant fixed costs can dramatically increase sales without a corresponding increase in fixed costs, which would increase average profit margins, perhaps enough to cover costs.factoring.
Large, successful companies are more likely than SMEs to generate enough cash to simultaneously finance operations, investments, and even debt payments. In other words, mature companies are less likely to experience a liquidity crisis that factoring can alleviate. However, many large companies still choose to finance their accounts receivable for others.Reasons.
ADVANTAGES OF ACCOUNTS RECEIVABLE FACTORING
The most obvious benefit of factoring is the improved cash flow that comes from the almost instantaneous conversion of receivables to cash, but there are less obvious benefits as well. Factoring makes it possible for companies that need itthey-CasaExperience in credit management to benefit from the experience of the factor. Experienced factors can quickly determine who to talk to about payments, track payment cycles, and implementconsequences-aboveProcedures to ensure payment expectations are met. Factors may also be willing to provide you with useful statistical reports on your debt collection activities. Additionally, many small business owners view invoicing as a hassle, but may not realize that they can outsource this business function to a factor. This would allow them to focus on operations instead of wasting time chasing customers for money, which could damage customer relationships if fixed.excessive.
Another potential advantage of factoring over most other forms of financing is that it is not dependent on the creditworthiness of the SME. Rather, it is tied to the quality of accounts receivable: the solvency of the middle class.Customers.
Finally, the availability of cash is closely linked to the performance of the business. Factoring ensures ever-increasing liquidity with ever-growing accounts receivable, which is an advantage for growing businesses, because sustainable sales growth requires aAlways-increasinglyAmount of cash allocated to working capital. However, it should be noted that the opposite is also true. When sales are flat or declining, so is cash flow from factoring deals, when cash needs are greatest. But even this can be seen as an advantage, as a liquidity crisis can more quickly draw management's attention to the issues causing lost revenue (see the Getting Started with Factoring box).
DISADVANTAGES OF DEBT FACTORING
Whether factoring is suitable for an SME does not depend solely on operational characteristics. Two ubiquitous criticisms of factoring should always be kept in mind. The knee-jerk objection of some consultants is that factoring is expensive, that's true. Annual fees can be in the single digits, but can also exceed 20% depending on the quality of the accounts receivable and the expected collection time. The fees may seem small at first glance, but when the factor charges a 1% fee for the cash advance that would have been collected within 30 days anyway, the actual fee is closer to 12% per year.
A second objection to factoring is that it can give a bad impression to mid-market customers. This risk exists because the factor, an independent third party in the eyes of the SME client, pays the fees, which may give the client the impression that the SME is in financial difficulty. Even more important is the risk to the customer relationship if the customer is frustrated when he detects a communication failure with the SME. For example, consider how customers might feel about addressing a factor related to billing disputes. The reputational risk of SMEs is difficult to quantify, but it is not negligible. However, the benefits of factoring often outweigh the opportunities.Disadvantages.
Note that the factors generally represent a UCC (Uniform Commercial Code) security interest to the SME before the funds are available. The UCC is a state law that is often used by a lender to attach collateral to loans in the same way that real property is used to secure mortgages. This protects the part of the credit of the factor in case of insolvency of the SME. However, it also prevents the SME from refinancing with other factors or financial institutions until the deposit is cleared, which the factor can easily do when entering into the factoring agreement. Before signing a guarantee contract, the SME must ensure that the guarantee is correct.described.
SMEs may want to be able to respond to changing circumstances when they feel factoring is no longer right for them. As such, they should be aware that most factoring agreements are forward contracts with terms ranging from six to 24 months. Find out what the penalties are for early termination of the contract, if applicablepossible.
A SUPERIOR STRATEGY
Even if it is a temporary solution, factoring may offer a better remedy.Money-tiedBusinesses such as credit cards, which are often used as a source of quick money. Factoring is certainly not to be dismissed lightly, because in addition to quick money, factoring also offers insights into liquidity and credit management that a typical midsize company often lacks. To illustrate how valuable this knowledge can be, consider the additional sales required to recover a bad debt loss. For any business with a 5% net profit margin, recovering a $1,000 loss due to bad debts requires an additional $20,000Sale.
Whether factoring or not, business owners need to know that the quality of their accounts receivable can mean the difference between success and failure. Hence the most importantlanguage-runThe advice for an SME in accounts receivable is to foster a collaborative and non-adversarial sales and collection relationship, as effective risk management is a collective responsibility.
How to start factoring
Going into factoring is not complicated for a small business that, after careful consideration, decides that the benefits of the strategy outweigh the drawbacks.
The first step is to find an appropriate factor, and perhaps the easiest way to do this is with an Internet search. For example, the International Factoring Association maintains an online membership directory (available atfactoring.org) that you can search based on a variety of criteria, including geographic location and industry specialization.
When interviewing a potential factor, be sure to ask the following questions:
- How long have you been in business?
- Do you have experience in my industry?
- Do the contracts contain a minimum amount of accounts receivable?
- What is the discount rate and what are the additional fees?
- How will you contact my customers?
About the authors
Charles R. Pryor, Ph.D., is a professor of accounting andStephen S. Gray, DBA, is an assistant professor of finance, both at Western Illinois University in Macomb, Illinois.Nicholas C. Lynch, Ph.D., is Professor of Accounting at California State University, Chico.
To comment on this article or suggest an idea for another article, please contact Ken Tysiac, theJofAchief editor,NOKenneth.Tysiac@aicpa-cima.com.
- "Asset-Based Finance Fundamentals, "JofA, August 2011
- Statement of Cash Flows: Preparation, Presentation and Use(#VCL4FCFS20120, online access)
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