Factoring: Is it right for your SME?
Small firms can access several sources for their financing needs. If your business has a good credit record and has been in existence for some years, a bank loan could be your best option.
But meeting a bank’s eligibility norms could be difficult if your firm has been recently established or if it has not attained profitability. Banks can also take several weeks to decide on a loan application.
One option for firms in the B2B space that supply goods on credit to their customers is factoring. This type of financing has several advantages and small companies should closely examine whether they can use it improve their liquidity position.
Here is a description of the benefits that factoring can offer.
1.You can free up your cash flow
A small firm may get the opportunity to fulfil an order that is of a far greater volume than usual. If it accepts, it could register a significant increase in its business volumes. But the buyer may demand a 60 or 90-day credit period.
Faced with such a situation, an entrepreneur may have to raise a large amount of working capital. Doing this at short notice may be difficult.
If the buyer is a government company or a firm with a sound credit rating, invoice factoring may offer the best way out. Instead of waiting 60 or 90 days for the customer to pay, the seller could obtain funds in just a few days.
Here is how the transaction will work. The lender (factoring company) will review the invoice that the seller has raised on the buyer. Immediately, funds will be released to the seller. Of course, 100% of the invoice value will not be paid. In the normal course, between 75% and 90% of the invoice amount will be provided to the seller.
On the due date of the invoice, the factoring company will collect the dues from the buyer. After deducting its charges, the remaining amount will be reimbursed to the seller.
One of the advantages of invoice factoring is that lenders do not need to carry out a lengthy credit appraisal process. Your small firm will not be subjected to a detailed financial review.
Invoice factoring gives your firm the opportunity to expand business volumes without having to go through the trouble of raising additional working capital from external sources. The increased sales volumes that your business generates allows you to raise funds immediately.
2. Lender’s decision is based on your customer’s credit rating
Banks are often reluctant to extend a loan to a small business. Private companies can have a difficult time proving that they have the ability to repay the money that they want to borrow.
It is usually necessary that you must meet each condition that a bank stipulates. For example, the bank may say that your company should have been in existence for a certain minimum period of time. Your financial statements should meet the standards that have been set by the bank. You may also be required to provide a personal guarantee or security of a certain value.
However, if you are applying for an invoice factoring facility, you do not have to meet most of these requirements. Instead, the factoring company will base its decision on whether it will extend finance, on the credit worthiness of the buyer.
The reason that it does this is simple. On the due date of the invoice, the factoring company has to collect payment from the company to whom you have supplied goods. If that company has a track record of meeting its financial obligations on time, the lender is highly likely to receive repayment promptly.
3. Invoice factoring frees up your resources
The success of a small business often depends upon its ability to keep its manpower costs and overheads low. It cannot afford to employ staff to track repayments from customers and to follow up for its dues. Hiring even one additional worker can sometimes place a great financial strain on the enterprise.
Small firms that face these constraints find that invoice factoring can be of tremendous help. The factoring company has staff that specialises in collection. You don’t have to waste time on these matters. Remember that the factoring company provides this facility to many private companies.
In fact, when it collects the payments that are due against the invoices that you have raised on a certain buyer, it may be conducting the same activity for multiple suppliers like you. This allows the factoring company to keep its costs low.
If you don’t have to worry about calling customers for payment, you will have additional time to concentrate on your core business activities.
4. Quick lending decisions
A factoring company can establish a facility for your firm in a matter of days. This is because it is taking a credit decision based on your buyer’s ability to pay for the goods that it has bought from you. It is quite likely that the lender already knows whether the buyer has a record for paying its dues promptly.
For small businesses, the speed of a lender’s decision-making process could be a very important consideration. If a private firm is unable to tie up finance quickly, it may have to pass up an attractive business opportunity.
A lender can make a decision on an invoice factoring proposal very quickly. This could prove to be of great benefit to a small enterprise.
Invoice factoring is not suitable for every business
While it is true that invoice factoring can deliver immediate liquidity to a firm, there are some categories of businesses which cannot use this mode of finance. If your business has a high percentage of returns, don’t turn to invoice factoring. You will have to spend a great deal of time in sorting out administrative issues and reconciling your accounts.
Companies that sell to retail customers or those that do not provide credit, cannot use invoice factoring. But, if your firm regularly sells to other companies on credit, it could be the perfect way to raise finance quickly and with a minimum of documentation.