Ted Turner, founder of TBS, TNN, CNN, and Cartoon Network, says that, “Life is a game, and money is how we keep score.”
For the 29 million businesses in the United States—28.7 million of which are classified by the Bureau of Labor Statistics as small businesses—money is certainly a very important record-keeping tool to determine how well or how poorly a business is operating. The numbers don’t lie in this regard, as the income statement of a business will determine if it is bringing in revenue, managing expenses properly, and if it’s generating enough profits to justify continuing—or to terminate the model in favor of greener pastures elsewhere.
For a significant percentage of the 29 million businesses, the fundamentals of their business model might in fact be strong in terms of creating revenue, competently managing expenses, and being able to generate a good profit margin. However, the culprit might be their slow-paying customer base that creates inefficiencies within the business.
Pro tip: What you don’t know can kill your business
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Some customers might take 10, 15, 30, 60, or even 90 days to provide full payment after a product or service has been rendered. If the business that serves those customers is not properly capitalized, this 10- to 90-day payment delay could cause cash flow issues, where there might not be enough cash inflows to handle the required cash outflows. Cash flow issues could spell an early demise for a business, in spite of having a solid business model.
The official and legal connotation for a 10- to 90-day outstanding payment due to a business is “accounts receivable,” which is a claim held by a business against its customer, based on services or products already rendered.
How Accounts Receivable Factoring Could Be the Answer
Using accounts receivable factoring could be important for your business if you are in fact operating within an industry where customers are usually granted—due to competitive reasons—10 to 90 days, or more, to pay for services.
Accounts receivable factoring can be the answer in the search to protect the cash flow of a business, allowing a business owner to continue managing cash outflows—paying payroll, vendors, suppliers, property costs, etc. At the same time, this allows their clients the competitive advantage of paying 10 to 90 days in full, which can either help maintain client loyalty, or help the owner in winning the client’s business in the first place.
Keep in mind that accounts receivable factoring can have relatively high rates, and there are other options, including business credit cards, that could offer lower rates depending on your business credit score profile.
400 Years of Factoring
The concept of “receivable factoring” has been going on in the United States since the 1600s, when various colonists sought individuals to advance payments on raw materials that were being shipped to England.
Just about any business that offers payment terms to their clients could benefit from factoring. This includes the more well-known clients of factoring companies, including companies in industries such as:
- Contractors, especially those who sell to the government
Other types of industries within the broad categories of retail and wholesale could benefit from the use of receivable factoring if they run into a cash flow crunch. However, the typical businesses that receivable factoring is best for are those that classify themselves as B2B (business-to-business) and B2G (business-to-government).
It All Begins With the Net D
Although some businesses are just “kind-hearted,” most are seeking to establish a competitive advantage in the marketplace when they allow their customers 10 to 90 days to pay for products and services already rendered. The practice of allowing their customers 10 to 90 days to pay is known as “Net D,” another name for “trade credit,” which represents how much of an outstanding invoice is required to be paid in full within a particular number of days.
Trade credit is one of the largest sources of financing utilized in the United States in general, and perhaps the biggest source of financing utilized by businesses. Certain clients might be provided a discount if they pay their invoices before the deadline.
For example, a contractor would issue an invoice for $7,500, with terms that list “5% 10, Net 30.”
This would represent that the invoice is due in full within 30 days. But if the client pays the entire bill within 10 days, they will receive a 5% discount ($375) off of the outstanding invoice amount, and would just need to pay $7,125. The creation of this invoice with Net D creates the “accounts receivable,” which becomes an actual asset that is listed on the balance sheet of the business that rendered the services.
How Factoring Works
With accounts receivable factoring, you will have a factoring company (known as a buyer), and then you will have the merchant looking to sell the outstanding invoices/receivables from their balance sheet (known as the seller). The factoring company will first buy the invoices/receivables off of the merchant’s balance sheet, then turn around and advance anywhere from 60% to 80% back to the merchant. The remaining 20% to 40% is advanced to the merchant after their client completes payment in full, minus a discount fee that usually ranges from 1% to 7%, depending on the credit and risk profile of the merchant’s clients. (Yes, it’s your clients that are being evaluated instead of you, because the factoring company is taking on the invoice in expectation that your client will pay it.)
Most factoring agreements are done on a non-recourse basis, where if the merchant’s clients do not complete payment as scheduled, the risk/loss of non-payment would fall on the factoring company that bought the invoices/receivables. However, in some cases you could have “recourse factoring” where even though the merchant could still be held liable for losses if clients do not complete full payment.
Canadian businessman Robert Herjavec says that “cash is the lifeblood of a business,” in that cash operates similar to how real blood works within the human anatomy by supplying the essential nutrients to life-flow. So accounts receivable factoring could in fact be the paramedic that saves the existence of a business during those times of “blood clot.”
As mentioned, Net D, or trade credit, creates the “accounts receivable,” which, if not managed properly, could lead to cash flow issues for a business (blood clots) that could choke out its existence. One way to address this problem is to factor accounts receivables.
However, there are other methods to handle accounts receivables, which include a form of asset-based lending called accounts receivable financing, as well as a very similar method known as purchase order financing. Credit cards and lines of credit are another way to deal with bridging the purchase-payment gap. In the next discussion, I will touch on these options, and how your business could utilize these tools to avoid a cash flow crunch.