Businesses that sell goods or services to their customers on credit will always have a gap on their books as they wait for payment. For example, if you own a construction company and you delivered an invoice after finishing a project, you might have to wait up to 90 days to receive payment.
This wait can create a cash flow problem with more money going out than coming in. Receivables financing could help bridge this gap, helping you cover your expenses while you wait for payments, or “receivables,” on past sales.
But, what is receivable financing? Well, it’s available in two forms:
- Receivables loan
- Factoring, or selling your receivables to a third party
The choice between receivables financing vs. factoring depends on the nature of your business and whether your business is mature or growing rapidly. So, let’s take a look at both.
How Does a Receivables Loan Work?
A receivables loan is usually set up as a line of credit, like a credit card. You can make draws against the line of credit to cover your operating expenses, then you just pay down the line of credit any time you have cash available.
Depending on the quality of the receivables and creditworthiness of your customers, these cash advances can range from 70% to 90% of your receivables. The financial institution usually requires the borrower to commit all of their receivables as collateral to secure the advances.
The borrower still retains ownership of the receivables and is still responsible for collecting the invoices from its customers.
How Does Factoring Work?
Factoring is when a business sells its receivables to another company (this external company is known as a “factor”). The factor buys the invoices and immediately advances a percentage to the business, holding the remainder until it’s paid. After the factor collects the entire invoice amount, the original business receives the remainder of the balance minus the factor’s fees.
The amount of the advance depends on the debtor’s creditworthiness and the duration of the receivables in play (30 days, 90 days, etc.). When you sell your receivables to a factor, you don’t have to provide additional collateral. The factor is only concerned with the receivables.
As such, the factor assumes the credit risk of the receivables and is responsible for collecting the full amount of the invoice. With factoring, your customer will pay the invoice directly to the factoring company. This means your customer will know you’ve financed their invoice, creating the impression you’re having cash flow issues.
Receivables Financing vs. Factoring
Because there’s a bit of nuance to the question, “What is receivable financing?”, let’s see which businesses are better suited for taking out a loan against their receivables vs. selling them to a factor.
Mature businesses are usually better suited for an accounts receivable line of credit because they have established credit histories, positive cash flows and strong balance sheets. Lenders will typically offer them lower interest rates and fees when compared to the charges often involved with factoring.
Businesses that have been around for two years or less, or are in a rapid growth phase, are better candidates for factoring. Take a budding trucking business, for example. As the business grows, the company will issue invoices to its customers, but it may not get paid for another 30 to 45 days.
In the meantime, the company has to continue paying its drivers and buying expensive fuel for the trucks, creating a significant cash-flow gap. Factoring its receivables is the best solution to get immediate cash.
Growing Pains
While you might want to keep all your financials in-house, it’s a great sign that you need to look into receivable financing. It means your business is growing at a rate you can barely keep up with.
Take some time to figure out the best method for your needs, and then watch as your business continues to flourish.
Need funds to grow your business in the coming years? Check out National Funding’s small business funding solutions or fill out our contact form to contact a representative.