Whether a business is growing too fast or the customers are paying too slowly, a cash crunch is the likely result. As companies grow, it is natural that more and more of their sales get locked up in receivables. While retailers may be immune to this particular problem, most businesses are not.

Imagine, for example, that a business is sending $10,000 worth of invoices each month. If customers take an average of two months to pay their bills, there can be as much as $20,000 tied up in unpaid invoices at any given time. In effect, the business is extending credit to its customers. Read on to find out how factoring can help make a business's cash flow in the right direction. If you own your own business, this option may be worth considering.

How It Works
Factoring works the following way:

  • The business writes an invoice to the customer, instructing the customer to send payment to a third party - the factoring agent.
  • The factoring agent pays the business a portion of the invoice immediately and another portion when the bill is finally paid by the customer.

Of course, there are many variations on this theme, including the size of the fees charged by the factoring agent and whether the business gets paid for delinquent accounts.

What It Costs
Factoring agents earn their fees by discounting the invoice value. For example, on a $100 invoice, the business might receive $75 upon presentment. Later, when the customer pays the bill, the business may get another $20. That leaves $5 for the agent. Over the course of a year, those $5 discounts can add up, often making factoring an expensive proposition.

What happens if a customer never pays the bill? The answer depends on whether the business has a full recourse or non-recourse agreement with the factoring agent. With a full recourse agreement, the factoring agent will look to the business to make good on the note. A non-recourse factoring agreement is more expensive because the discount rate on every invoice is higher, but once the business receives the money, it is theirs to keep. Of course, even with a non-recourse factor, there is shared risk because the business will not receive the second installment on any unpaid invoice. (For more insight on collections, see Measuring Company Efficiency.)

One of the best things about using a factoring agent is that it relieves a business's staff of some of the burden of processing accounts receivable (AR). Most factors take on the role of collections, calling accounts and matching payments with invoices. Because they are automated, they make bulk payments directly to the business' bank account. This leaves staff with the simpler task of tracking payments from the factor, which could help to streamline operations.

Who Is Suited
Factoring works best for businesses with customers that are sizable companies with good credit histories and the ability to pay their bills. Businesses that sell to the government, for example, might benefit from factoring because government accounts tend to be reliable, but payment is slow to come. It's also easier and less expensive to sell a few large invoices than a large number of small invoices. If customers are small or if the average values of the factored invoices are small, factoring may not be a good option because smaller receivables may cost the business more as a percentage. Likewise, small dollar-value invoices simply represent less overall cash to the company, so the benefit of outsourcing will likely be smaller. Shop around because factoring companies have different rates and fees.

Pros and Cons
Factoring is not done by banks, and there are few legal and regulatory protections afforded by other liquidity-enhancing options. Historically, factoring has been served by unsophisticated agents who charge exorbitant rates to companies that could not borrow money from other sources. Because of its association with troubled companies, factoring was often considered a "last resort", and was a sign of general financial difficulty.

As larger commercial finance companies have gotten into the game, however, factoring has become both reliable and more reasonably priced. These days, giant finance companies like CIT offer factoring as an attractive outsourced collections service. For good clients with good accounts, the price can be attractive too: the discounted invoice value can be about the same or even potentially less than the interest rate that is charged from a line of credit that a bank provides. All this makes factoring worth a look when a company's other credit is tapped out, or when no traditional bank collateral exists.

As an added bonus, a good factoring agent will help determine the credit-worthiness of a business' current and future customers. This kind of credit check can help reduce factoring charges, and could help prevent cash flow problems before they start.

Maximize the Benefit
Because factoring can free up large amounts of working capital, companies with large clients and large invoice values should consider factoring. More working capital means that it is easier to purchase more inventory and fund other short-term projects that can accelerate growth. (For related reading, see Working Capital Works.)

Depending on the company's business needs, some of the costs of factoring may be offset by taking an early payment discount for some of the expenses.