The Pros and Cons of Factoring: Is It Right for Your Business?

According to USA Today, per the U.S. Bureau of Labor Statistics, around 18% of small businesses don't make it to the end of their first year. About half fail within the first five years, and around 65% close their doors by the tenth year. Finances, or a lack thereof, are the primary reason for these closures.

You should do everything possible to avoid being part of those statistics, so you'd want to explore multiple business financing options. Factoring, also called factoring finance or accounts receivable financing, is one such method.

In this guide, our team at Riverpoint Capital will discuss the top factoring benefits and drawbacks you should be aware of. So please read on, as what you discover here can help determine if this practice suits your business.

Pro: Immediate Source of Funds

One of the primary benefits of factoring is that it provides your business with an immediate injection of cash. You can then use the funds as a capital source or to avoid defaulting on your business's loan payments with creditors.

Here's how it works.

Sample Scenario

Suppose your small business operates by allowing a part of your sales to be on credit. Also known as "credit sales," these invoices make up your accounts receivable, representing money your customers owe your business. According to Investopedia, credit sales are now the norm in businesses, dominating all B2B transactions.

Because your business can't immediately collect on credit sales, you may encounter issues with cash inflow. For example, you may be unable to pay your accounts payable on time because you can't get the receivables paid in time. You may also become cash-strapped, preventing you from being able to make your company's loan payments on or before their due dates.

Factoring to the Rescue

Factoring allows you to address the problems above by converting your accounts receivable to cash. You'll sell your receivables to an intermediary agent called a factor. The factor will then purchase your receivables and give you a same-day advance, helping improve your company's cash flow.

You can then use the cash as capital to fund your operating expenses, such as:

• Paying your employees, vendors, or suppliers
• Manufacturing or production costs
• Provision of services
• Settling your commercial utility bills

If you have existing bank loans, you can use the funds from factoring to pay them on time, reducing the risk of delinquencies. You want to avoid delinquencies and loan defaults because they can lower your business's credit score and mar its credit report. When these happen, they can make it more challenging for your firm to obtain credit in the future.         

Con: Fees Apply

One drawback of factoring is that it lowers your profit margin. After all, a factor is a business, so it must earn money, too. With factoring, the factor takes a small cut out of each invoice for commission and fees.

Pro: Your Factoring Partner Collects Invoices on Your Behalf

When you partner with a factor, you'll transfer the task of invoice collection to them. So, not only will they buy your invoices and pay you a portion in advance, but they'll make your life easier, too, as they'll recover unpaid invoices for you. They'll also follow up on customer payments, and once they've collected the entire amount, they'll refund it to you minus the agreed-upon fee.

Con: Higher Fees May Apply

The fees charged by a factor may depend on the creditworthiness of the customer paying the receivable. Per Experian, borrowers' creditworthiness primarily depends on three factors:

• Credit report
• Credit score
• Income

The more creditworthy borrowers are, the less risk they pose to lenders and creditors because they're more likely to pay their financial dues on time. So, if your customers paying the receivables are creditworthy, your factoring partner may charge lower fees.

Conversely, the less creditworthy they are, the more risk they pose (for example, of defaulting on the payment). In this scenario, the factoring company may charge a higher fee to compensate for the increased risk they're shouldering.

Pro: You Can Fund Your Business's Expansion

You can also use the funds from factoring to finance your business's growth. Some examples of expansion include:

• Hiring new employees or temps for seasonal influxes
• Upgrading equipment or facilities
• Researching and testing new products or services
• Investing in improved marketing efforts
• Moving your business to a better location
• Opening succeeding locations

With the help of factoring, you can grab opportunities you would otherwise have to pass up due to a lack of funds. So, while you may have to pay your factoring partner a (small) fee in exchange for the cash advance, it can be worth it because it gives you the potential to earn more in the long run.

Con: Not All Small Businesses Qualify

As businesses themselves, factoring companies also have to protect their companies' interests. For this reason, they may not always extend their services to all small businesses that wish to partner with them, such as those under one year old. Likewise, they may not accept invoices for customers with exceptionally poor creditworthiness.

Pro: Shorter Approval Window

When comparing factoring vs. other financing options, you'll be happy to know that the former often gets approved faster than traditional bank loans. If your application gets approved, you'll typically receive the advance on the same day.

So, with factoring, you can always have a steady source of funds since you won't have to wait months for your invoices to become liquid. 

Is Factoring Right for You and Your Business?

Now that you know the pros and cons of factoring, you can make a more informed choice when deciding if it's a good fit for your business. If it is, or you're still unsure, Riverpoint Capital will be happy to help.

We've been helping companies, big and small, get access to financing for over a decade now. Regardless of your business's size or the number of employees you have, we can provide you with tailored solutions to help improve your cash flow.

If you're ready to boost your working capital and grow your business, get in touch with us today. We look forward to helping your business succeed and expand.