Benefits of Factoring for Small and Medium Businesses

• By: IFA
• On: 07/24/2024 18:29:42
• In: Factoring 101
• Comments: 0

With stricter lending criteria, higher interest rates and limiting financial covenants, traditional bank loans can be harder and more expensive for SMBs to secure. Issues plaguing SMBs such as cash flow management due to delayed customer payments and seasonal fluctuations in demand, inventory and workforce, are often not solved by these restrictive lines of credit. In most cases, the need for speed and flexibility in a finance relationship are the key to success for SMBs.
 
Factoring offers these businesses quick and easy access to working capital, helping them manage cash flow, cover operational expenses? and mitigate risks, while not taking on debt or giving up equity in their business.

How Does Factoring Work?

Factoring, also known as invoice factoring, is a type of financial agreement where businesses sell their outstanding invoices to a factoring company in exchange for cash. The factor pays the business a percentage of the invoice amount upfront and takes on responsibility for collecting the full amount from the business's customer. Once the factor collects the full repayment from the customer, the factor will send the business the difference, minus the agreed-upon fees.
 
The concept is similar to a business offering their customer a 2% discount to pay in net 10 days, except with a factoring solution, the SMB is paid even quicker than that by the factor. Opting for factoring enables businesses to get paid immediately instead of waiting on their customers to pay them.

What are the Benefits of Factoring for Small and Medium Businesses?

Below is a breakdown of the advantages for SMBs in choosing factoring over other financing options:

Improved Cash Flow
When a business sells its invoices to a factor, it receives an advance payment, almost immediately, shortening the cash conversion cycle (CCC). This timely access to working capital enables SMBs to pay bills and cover payroll and other expenses without having to wait 30, 60 or 90 days for customers to pay their invoices.

No Debt Incurred
Traditional loans add debt to the business' balance sheet, but factoring does not since it isn't a loan. The factor purchases the invoices from the SMB at a discount, providing them with cash up front. This avoids the accumulation of liabilities on the balance sheet.

Debt can be detrimental to the current and future state of an SMB. Debt repayments can constrain a business's cash flow, limiting their ability to pay suppliers and employees on time, invest in growth opportunities, and maintain overall operations?. Rising debt levels bring higher interest costs and reduced creditworthiness of the business. In addition, high levels of debt increase the financial risk for SMBs since they could face a downturn or unexpected expenses and struggle to meet their debt obligations. In a worst-case scenario, crippling debt can even force a business into bankruptcy.

Easier Approval Process
It's expected that many new businesses could experience negative cash flow from operations. If they're not yet profitable or have a high debt-to-income ratio, they pose a risk to funders. It tends to be easier for SMBs to get approved by factors than traditional banks since factors focus more on the creditworthiness of the SMB's customers rather than the SMB itself. This is advantageous for businesses with limited credit history or collateral to qualify.

Risk Mitigation
Dealing with late payments and bad debt can be devastating to an SMB's financial stability. Risk can be transferred from the SMB to the factor in the form of "non-recourse" factoring. This means they assume the credit risk of non-payment by customers, protecting SMBs from potential losses due to bad debt.

Outsourced Collections and Credit Management
Many factors handle the process for collections and credit checks on customers, thus serving as an extension of the company's accounts receivable department. This allows SMBs to focus on core business activities like product development, sales and customer service, rather than having to spend time and resources on administrative tasks or chasing down payments from customers.

Support for Growing and Scaling
Business owners are always looking for opportunities to expand and grow. However, as they know all too well, growing and scaling a business requires an increase in working capital. It can be especially difficult for SMBs in certain industries such as transportation and logistics, staffing, medical, and construction to attain their financial goals since traditional lenders tend to shy away from those industries. Factoring enables SMBs to leverage their receivables and scale operations without the need for tangible collateral, and without having to give up equity in their business or take on debt.
 
As SMBs struggle with funding daily operations and high-level business initiatives, traditional loans from banks don't always offer them a solution. Factoring can be a viable alternative financing option for them. It enhances cash flow, while allowing businesses to avoid debt and risk.
 
The International Factoring Association (IFA) connects businesses with expert factoring providers who are bound by the IFA's code of ethics. To view a list of our current members, click here.