Exploring factoring for cash flow and some of the myths that surround it.
Cash flow issues are one of the significant factors for businesses going insolvent. An economic downturn can leave your business struggling. In a time of survival you need to lessen your money worries and focus on your core activities. Factoring can be one way of helping you managing your cash flow.
There were 5.9 million (2019) businesses in the UK, of which 99.9% are SME’s (employing 250 people or less). According to an article in HR News (C. Evans, 2019), almost 1 in 7 small businesses have been left unable to pay employees. 38% of businesses have failed to pay debts. And owners have to turn away work estimated at £26k per business p.a., and all because of cash flow issue.
Bad debt and cash flow issues, according to some sources, can account for up to 87% of all business failures. In this article, we want to explore whether factoring can help cash flow. Whether that is to survive current economic events or help support growth in your business. The Cambridge dictionary defines factoring, thus,. Factoring can also be known as invoice finance or asset-based lending.
“A situation in which a company buys the right to collect payments and debt owed to another company and charges for doing this”
How does factoring work
It works by company A (the client) selling its sales ledger to company B (the factoring agent). Typically company B will pay company A 75% to 80% of the value of the sales ledger. Usually, this is done over a fixed term period, typically 24-months.
Company B will manage the sales ledger for this agreed period. When an invoice is raised, company B will pay company A some of the outstanding amount – 75% to 80% – and then chase the end customer for payment. Once the end customer pays in full, company B pays the remaining amount to company A, less a commission.
The advantages of factoring
If turnover is vanity, profit is sanity; then cash is king. Business for many SME’s is all about cash flow, especially in the early years. Business to business terms are often 30 – 60 days, which in itself is long enough to wait for payment. However, you can easily find yourself waiting longer because your customer is also waiting for payment before they can pay you.
As a business owner, you may feel safer in terms of payment by securing work with more substantial companies but remain aware that larger companies can suffer cash flow issues just as quickly as medium and small companies.
Factoring can take the stress out of cash flow management, and you receive payment in a timely fashion. The factoring agents pursue payment from your customers, removing a lot of administrative work, allowing you time to run your business and not chasing debts.
The disadvantages of factoring
Factoring agents often want clients with multiple customers and are not suitable for a small clientele – one or two customers. There is often a negative association with companies using factoring agents, it is assumed that a company is in financial difficulties if it uses factoring.
However, the opposite is also true; a company using a factoring agency is often on top of its cash flow, therefore, in a stronger position.
Using factoring does mean that you give up some or all of your credit control. After building strong relationships with customers, you will be putting your reputation in the hands of others.
Be aware that many factoring agencies have extra cost that may not show up in initial quotations. These additional fees or disbursements can make factoring expensive. It is worth shopping around and finding out if additional charges apply. It can be better to pay an initial higher fee and no extra costs than vice versa.
Myths surrounding factoring
Your company is in trouble if it uses factoring?
As explained above, this isn’t necessarily the case. A growing business needs good cash flow as much as an ailing one. Factoring can make sense when you need to concentrate your efforts on your growth or survival and not debt recovery.
Factoring is expensive and you should use an overdraft instead?
An overdraft is usually linked to the capital within the business and often needs regular renegotiation. If the bank doesn’t cap your overdraft, then it is possible to overspend and incur unforeseen costs as a result. Managing an overdraft, alongside all the other requirements of running your business, means you can often overlook your spending. It isn’t hard to go over your limit.
Factoring, is about your sales ledger, which can often be higher than capital within your business. As your business grows, factoring won’t require renegotiating.
Shopping around and compare quotes could mean you paying around that you will same as an overdraft. The other beauty about factoring is that you do not have to put up collateral, unlike many bank overdrafts.
Do factoring agents control all of my sales ledgers?
Yes, this can be the case. However, some factoring agents allow you to select which invoices to factor and will enable you to keep others yourself. If you have particularly valuable customers, they pay on time and in full, then you may be able to retain these yourself. If you are considering factoring, ask any company you approach whether they consider this to be an option.
Factoring is a short term solution.
Not always, would be my response. Some companies use factoring to overcome initial needs such as business survival, other use it long term. It can take the bother of managing your sales ledgers and allow you to focus on what matters.
In 2016 we came across a small company specialising in welding. You would not deem either partner of the company as business savvy; however, they were great welders. After getting into cash flow issues they considered closing the company down. After a long conversation, it was agreed to use a factoring agency. Doing so removed stress from their lives and they could concentrate on their passion for welding. Even four years later, they still use factoring because of its convenience.
Will factoring agencies hound and harass my customer?
The quick answer is no; they won’t. Factoring agents do not want to harm your business. The fewer invoices you raise, the less they make, so they want you to keep good relations with clients as it means more business for them.
Customers have issues if you factor their invoices?
This isn’t the case, more and more companies are using factoring. I predict growth in this market after the economic impact of Covid-19 takes hold. As long as you ensure you are using a reputable company, then it isn’t usually an issue, especially if you are open about it with your customers.
Factoring a conclusion
There are alternatives to ensuring cash flow is maintained; you can chase your customers hard, put penalties on for late payments or discounts for early settlements. However, experience tells me these don’t always work, especially so if your customers are experiencing late payment issues. You don’t want to do is jeopardises your business because of cash flow and factoring can be one alternative worth exploring.
Harry Southan, 20/07/2020.