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Solve Liquidity Problems By Using Invoice Factoring
Liquidity is the term used by financial experts to describe the ability of a business to raise cash quickly. Businesses with poor liquidity may struggle to remain streamlined, even if their balance sheets are healthy. Once of the most common causes of liquidity problems that many businesses face is the time gap between having to pay for goods or services used and receiving money from sales.
Liquidity problems most often arise for small to medium enterprises (SMEs) that sell goods or services to other businesses and/or public services on credit. Typically, these customers will be offered terms that mean they are not expected to settle invoices for some time after the goods or services have been supplied.
SMEs may also have credit facilities from their suppliers, which offset some of the problems caused by having to wait for payment from their customers. However, the SME will have ongoing costs that must be met, such as utility bills, payroll, services, loan mortgage repayments, debt servicing, or rent. Invoice factoring is a useful solution to this problem.
What is invoice factoring?
An invoice represents a debt, and debts are essentially financial instruments that can be bought and sold. Invoice factoring involves SMEs selling debts to a factoring company. That company will buy the debt for an amount slightly lower than the debt; 2 percent is a common discount, although the percentage can be higher than this. An SME that sells a $1,000 debt to a factoring company that charges 2 percent can expect to receive a total of $980 from the factoring company.
Factoring companies do not pay the entire amount due immediately. They will withhold some of the money until they have received payment from the SME’s customer. However, the factoring company will pay the SME a significant chunk of the total, typically 70 percent to 90 percent, within one or two business days of buying the debt.
Benefits of invoice factoring
The benefits of invoice factoring can be best appreciated by looking at the alternatives. Businesses that have liquidity problems will need to raise cash somehow. Getting a bank loan is one of the most widely used solutions. That process can be lengthy. It requires the SME to meet lending criteria, and there is no guarantee that a loan application will be successful. Another option is to get an equity loan on assets that the business owns, or on assets that are the property of the business owner, such as his or her residence. This can also take time. Both these methods of raising money mean the SME is incurring debts
Yet another option is to sell shares in the business. This can also take time, and it may mean handing over some control of the business to third parties.
The most obvious benefit of factoring is that SMEs have a vastly improved cash flow for a relatively low outlay. Factoring costs are often lower than interest rates on borrowed money. The process of factoring is also much easier than trying to arrange loans or selling a share of the business.
Invoice factoring also removes responsibility for collecting debts from the SME, as this function is taken over by the factoring company. This may free up human resources within the SME, or reduce the amount payable to a third-party accounts management company.
Downside to invoice factoring
The only downside to this method of improving cash flow is that factoring companies will not take on debts unless the debtor is either an established business with a good credit rating or a public service/government department. That means that SMEs that sell to individuals or small, startup companies cannot avail of invoice factoring.