Has your small business developed a dependence on factoring loans? The below strategies can help if you are ready to start fixing your cash flow issues at their root and explore other options to help you access the cash you need in the meantime.
What is a Factoring Loan and When are They Used?
A factoring loan, also known as invoice financing or asset-based lending, allows business owners to use unpaid customer invoices as collateral in a loan agreement. For businesses that are faced with pressing cash flow challenges due to slow paying customers, factoring is an attractive option. Most factoring companies can approve an application in as little as 3-5 days; traditional bank loan application processes can take weeks, even months. Bank loans can be even harder to come by for small businesses with subpar credit, negative equity, unfamiliar/new business models, or any other “risk” factor (as perceived by the bank’s underwriter).
Strategies to Free Small Businesses from Factoring Loans
If a business is caught in a cycle of factoring loan reliance, the first step to get on track is understanding cash flow. Where is the crunch coming from? With the right help, fixing margins and cutting spending can be a great source of extra cash used to pay off and reduce factoring and high interest loans.
Identify the Source of Cash Flow Issues
At its root, the need for a factoring loan is to solve a cash flow issue fast. This can be due to slow paying customers – but it can also be due to low margins or high spending levels. If it is one of the latter two, then factoring loans can exacerbate the issue. A business operating with below-market margins and above average spending is never going to generate the additional cash flow to end its dependence on factoring. Some helpful tips are below, but a virtual CFO is another cost-effective way to get financial help to get cash flow back on track.
Improve Cash Flow
Improving the cash flow cycle is important step in eliminating dependence on high interest factoring loans.
- Reduce inventory of raw
materials, work in progress (WIP) and finished goods.
- Invoice quicker for services and/or shipped products. This starts the collection clock running and shortens the cash flow cycle.
- Enforce payment terms. Stop extending free credit to the slow paying customers.
- Follow-up on slow payers. Have a formal, standardized process in place for slow paying customers. If they know they are going to get a call following up on unpaid invoices they are more likely to pay on time.
- Offer discounts to customers for quick payment that cost less than what the factoring/interest charge would be.
- Try to factor invoices for longer paying customers but expect some resistance from the factoring company.
- Accept credit card payments (again, assuming the merchant service charges make it cost effective) to give customers another, convenient way to pay.
Obtain A Line of Credit
Get a line of credit and use that to reduce dependency on factoring. Lines of credit must be paid off once per year so be sure to understand the ramifications of using it. A line of credit will have a lower effective interest rate than factoring but will require the bank to underwrite the business. While a business that is struggling with cash flow may not be able to obtain one, businesses that can should opt for this solution.
Exception Cases for Factoring Loans
While I typically advise against dependence on factoring loans, there are a few cases where factoring loans can serve as a financial tool.
Larger Companies Requiring Longer Payment Terms
Accepting longer payment terms – 90 days or longer – can negatively impact cash flow. It is not uncommon for larger businesses to require these terms. If you are certain that customers will pay within these terms, factoring loans could be a safe way to get paid immediately on invoicing.
High Growth / High Margin Companies
For a business with either/or high margins and high growth, factoring might be a good solution. For these businesses, the time value of money may mean that the speed at which they can factor invoices is worth the associated fees and interest. The opportunity cost of missing out on new sales/customers could cost more than the factoring. Again, the key here is use factoring as a tool, not a lifeline.
The Risks of Factoring Loans
While high interest or factoring loans may be the appropriate option in some business situations, it is important to consider the risks and cons of the business’s dependence on them.
High Interest Rates
Factoring loans come at higher interest rates than traditional bank loans. Factoring loans can cost the business as much as 4% over 30 days. While some businesses see factoring loans as a method to end cash flow problems, it does not solve the accounts receivable issue at its root. The business is still paying the factoring loan fees and high interest rates, which means slow paying customers are still causing a cash issue for the business. Yes, the business is collecting cash faster, but it is still collecting less cash than it would if the factoring company did not take a cut.
Damaging Customer Relationships
Factoring business loans change the nature of the relationship with customers. Invoices become the factoring company’s responsibility – which means they are communicating with customers. They could potentially treat customers differently than an in-house A/R team – which impacts both brand and reputation.
Debt Could Boomerang Back to the Owner
In a recourse factoring agreement, the amount owed is still the responsibility of the business if the customers never pay the factoring company. The business could be left paying high rates and fees in addition to finding a way to pay the amount owed for the unpaid invoices. Some factoring companies that will offer terms where they take all responsibility for collecting A/R (non-recourse factoring) but again, refer to the section above about damaging customer relationships.
- Factoring is best used as a tool in the financial toolbox, not a lifeline.
- Improving cash flow issues at their root is a first step in ending dependence on factoring loans.
Jeff Heybruck is the founder of Lucrum Consulting and brings more than fifteen years of accounting experience and financial expertise. Jeff holds a Master of Accounting from UNC-Charlotte. You can reach him at [email protected]