The demand for small business financing is high; unfortunately, as a small business owner, the odds of securing a business loan are not in your favor. Last year, in 2018, large banks approved only 25% of business loans, and small banks approved 49% of loan requests.
Many small businesses struggle to get that additional "boost" of capital needed to move their companies forward, and these lost growth opportunities are the highest costs borne by businesses with inadequate working capital financing. Fortunately, there are alternative options for business owners in need of immediate funding; one of these options is a method known as factoring.
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What is business factoring?
Factoring involves the purchase of corporate accounts receivable by a third-party company. For many companies, factoring can mean the difference between fighting to stay afloat and having the money to take advantage of opportunities to grow the business.
Here's how factoring works: Say a business has $100,000 in accounts receivable outstanding. There is a gap between the collection of the accounts and the needs of the company to pay salaries, suppliers and the costs of new projects. Before the credit crunch, the business might have gone to a lender and received a loan backed with the accounts receivable. Today, though, those loans are harder to come by. That's where a factoring company comes in. [Read related article: A Guide to Choosing the Right Small Business Loan]
When is business factoring used?
Some 40% of small business owners apply to take out a loan just to cover operating expenses like payroll and electricity. By purchasing a business's outstanding invoices, factors can provide timely funding to help make payroll, complete projects or even expand operations.
Factoring helps businesses in countless ways: Balance sheets become more attractive, financial positions are solidified, cash flow is enhanced, late penalties and fees can be eliminated, discounts from suppliers can be earned, and credit ratings improve. These improvements can put the company in a better position for future opportunities. [Interested in learning more about factoring services? Check out our best picks and reviews.]
Generally, any B2B company that has the ability to increase its sales but is held back by a lack of capital can benefit from factoring. The industries that tend to use factoring most frequently are service-based, because they have a high labor component and must pay employees weekly. For example, in 2017, transportation and technology businesses were the largest business segments for factoring. These businesses need funding to sustain longer sales cycles, and the accounts receivable collections are on a different and longer schedule. Without factoring, such companies wouldn't be able to expand.
What does the factoring process look like?
The biggest advantage of factoring is its rapid turnaround. Typically, businesses can get funds within one or two business days. Factoring differs from traditional bank loans because the credit decision is based on the quality of the receivables rather than other criteria – how long the company has been in business, financial ratios and personal credit scores, for example – that a bank would take into consideration.
In general, the factoring company will advance 80% of your invoice. When you pay the due invoice, the factor forwards the remaining 20%, minus fees. Factoring differs from equity financing in that factors don't take equity in the company and do not interfere in management. Since contracts are short-term, the client elects to stop factoring whenever they choose.
Each company's cost of factoring is based on their risk, industry and market position. For companies that struggle to secure bank loans and need additional capital to make ends meet or take advantage of growing market opportunities, factoring may be a solution.