Raising capital and predicting cash flow are constant challenges for many businesses. Capital that may be needed to undertake a project, fuel growth, or simply meet obligations may, at times, be unavailable because of the unpredictable nature of accounts receivable.
While some companies raise capital by issuing equity or taking on debt, those methods may not be ideal for some businesses. Issuing equity dilutes ownership. Taking out a loan or line of credit adds more debt to the balance sheet and may not even be an option if the company’s credit doesn’t meet bank standards. These are but a few of the reasons why many businesses are turning to a third option called invoice factoring.
Factoring Credit Lines
Invoice factoring has been around for centuries and in some industries, like textiles and clothing manufacturing, it has long been a routine part of doing business. Invoice factoring has recently grown in popularity because it allows companies to leverage their accounts receivable to access capital immediately without adding debt or diluting equity.
In a factoring transaction, a business sells its accounts receivable to a third party, called a factor. The factor can compensate for the business in one of two methods. In advance factoring, the factoring companies advance a portion of the receivables to the business. The advance is typically 80 percent to 90 percent of the total receivable balance. The factor then collects on the invoices, deducts a commission and other charges, and then pays the balance to the business.
While factoring may sound like a loan against receivables, it is not. Under GAAP, the transaction is considered a sale. Moreover, a transaction differs from a loan in the way it is underwritten. In a loan, the lender or bank would consider the creditworthiness of the business before approving the loan. In factoring, the factor is less concerned with the business’s credit and more concerned with the likelihood that the invoices will be paid.
Businesses use factoring to their advantage in a number of ways. The most obvious use is to raise capital to meet obligations when there is little cash on hand. Factoring can help a business through challenging times without adding debt to the balance sheet.
However, companies can also use factoring as a strategic tool. Many customers wait as long as possible to pay invoices, essentially using the business as a short-term lender. The business can take back control of their cash flow by factoring in the invoices, obtaining much of the cash immediately. They can then use that cash for more urgent matters that can contribute to and fuel the company’s growth.