Factoring can be a great tool for a small business to get a leg up in the world, have someone else manage some of the business problems like collections, and provide needed cash flow when things are tight. However, it has to be approached the right way, the terms have to be understood and clear, and it has to work for both businesses if it is going to be successful.Here's what small businesses should know about factoring.
1. What is factoring?
Factoring is where a business purchases customer invoices from another business at a fraction of the price. In other words, if you have unpaid invoices, you could sell the right to collect on the invoices to a factoring company. You get maybe 75% of the face value of the invoice, and they get to collect on it.
2. Credit matters.
One of the reasons factoring is successful is credit. If you want to use factoring for your small business, you have to have invoices backed by established credit histories, and strong credit. In other words, a factoring company is not going to want to buy an invoice that is from a consumer with poor credit, because it means the likelihood of being able to collect the owed amount decreases. Thus, only work with businesses and consumers with strong established credit. This is going to give you better percentages, and more protection.
3. The company.
The factoring company you choose to work with will make a difference in how successful the endeavor is for you. Ask the following questions:
- What is the minimum annual invoicing amount? Can you manage that?
- Who will deal with collections? If it is you (the owner), say no, as that is one of the reasons you are selling the right to collect at a discount.
- What will the company factor for? Products? Services? Both?
If you can't find a good factoring company to work with in order to get the cash flow you need, another option is to hire a company to manage the collection on invoices. Paying a higher percentage out for earlier paid invoices can add incentive for early payment, which can result in you getting the cash flow you need. Of course, it might be worth trying a combination of the two, using a factoring company to get on track financially, and then hiring a collection company to help you stay on top of invoices so that you do not need to continue using factoring in order to stay liquid.
Factoring is not the best business finance option for everyone, but if you have a lot of unpaid invoices, that are from credit worthy customers, and you do not have the time or the resources to do the collections yourself, factoring might be the perfect answer for you.