Say your company makes a product and a major retailer has just sent over a large purchase order. Good news, until you look at the bank balance. How are you supposed to pay for the raw materials? How are you going to cover the labor and shipping and everything in between? And the worst part: when are you going to actually get paid for the order itself? The truth is, almost every small manufacturer gets tripped up by this tension between revenue and cash flow. You know you’ll eventually collect, but you don’t have the working capital to bridge the gap.
Most of the cost of making and shipping that order lands long before the retailer receives the goods, let alone pays for them. Where does that money come from? You could sell a piece of the company, or the owners could commit additional personal assets, but they’re probably already tapped out. There are also bank loans and letters of credit. But it’s difficult to raise capital without diluting ownership or taking debt on the company. The last option is to factor the receivables you already have outstanding.
Then comes the wait. Retailers almost always pay on terms, usually 45 to 90 days after the goods arrive. But there is a problem, and that is, almost no one wants to wait 45 to 90 days for their check. It’s important to remember that you still paid the expenses up front. So you’re out that money, too. And you probably need the money from this sale to make the next order and cover payroll. Meanwhile, your bills are due. And they don’t care that you have a big contract with a national retailer. They only care that you don’t have the money you owe them. Retail factoring is a financing solution that helps fill this gap between payments and expenses. It’s not the only solution, of course. But it can be the right one for some small businesses.
Selling Your Right to Collect
With factoring, you sell your outstanding invoices to a third-party finance company, called a factor. Factoring is basically just selling your right to collect at a discount. It’s that simple. Another way to think of factoring is this: it’s a way to get access to your accounts receivable now, rather than in 30 days or 45 days or 90 days. It’s not a loan. Factoring is simply a financing tool that you can use to advance the cash you’ve already earned. Who can use retail factoring? Any supplier who sells goods directly to a retailer. If your store only sells to shoppers at the register, there is no invoice to sell.
The advance rate and fee are agreed when the account is set up. The factor typically advances 80% to 95% of the invoice the same or next day, so on a $50,000 invoice at a 90% advance, you have $45,000 in hand and you don’t have to go to the bank to get it. The factor holds the other $5,000 as security and collects from the retailer over the next 30 to 90 days. Once the invoice is paid, you’ll get your $5,000 reserve back, minus the factor’s fee.
Qualifying is fairly simple. The invoices must be for products that were delivered and accepted. A factor also wants to make sure that the retailer you are selling to is credit-worthy. So you actually have to have a customer who is going to pay your invoices. Most lenders look closely at your business, its health, its potential for success. But factoring involves the finances of a third party, usually your customer, not your business. Factors don’t require a set time in business or a particular owner credit score. If you have a bad credit rating, or can’t get a loan from a bank, you may still be able to get financing through factoring. Your current financial health doesn’t have to be your undoing.
When a business doesn’t have the financial resources to bridge the gap between expense and revenues, it can miss opportunities or stymie growth. Factoring helps those businesses keep their legs moving. The factor will give you the immediate cash you need to cover production, shipping, labor, etc. You will be able to take orders for goods that you don’t have the working capital for. With retail factoring, you avoid the wait and focus on production and growth. Factoring also isn’t a one-time deal; as long as you keep shipping to good customers, you’ll always have new invoices to sell. Small companies without the established histories and assets to qualify for traditional financing can get factoring services. Since you’re not borrowing against your invoices, you’re not taking debt onto your company’s balance sheet.
Factoring Isn’t Free
Factoring isn’t free, you will have to pay a fee. Pricing depends on risk, volume and other details, but it typically runs 1% to 2% of the invoice value for every 30 days it stays unpaid. On a $100,000 invoice, that is $1,000 to $2,000 if the retailer pays in 30 days, $2,000 to $4,000 at 60 days and $3,000 to $6,000 at 90 days. The slower the retailer, the more you pay; the faster they pay, the cheaper factoring becomes. On the surface, that may sound like an awful price. But is it really that bad when you consider the alternative?
Whether it’s worth it depends on what you mean by struggling. If your customers are paying slowly, factoring can get you the cash you need. Factoring isn’t a complete source of funds for your business. But it can bridge a cash flow gap until your customer pays their invoice. However, if your business is already struggling to pay its bills, you cannot use retail factoring to dig your way out of debt. It’s a source of working capital. Not a place for your business to dig a hole. Factoring is a little like a life preserver, a good way to keep yourself afloat, but it’s not the end-all be-all of all things.
Is It Smart
If you decide to go ahead, setup usually takes one to three weeks. You fill out an application and submit it to the factor. Once you agree on terms and sign a contract, you send over copies of your open invoices with any backup documents. The factor checks that the invoices are good and that your customers will pay into its lockbox.
So, is it smart? With the right partner, yes. It can provide the cash you need to hit production deadlines, pay your suppliers and employees. It can help you grow when you’re struggling. Just don’t rely on it to get you out of debt. If you need cash and you don’t have time to wait 30, 45, or 90 days for your customer to pay, you might just have a perfect match for retail factoring. The bottom line, retail factoring is a solution to help you cover your short-term expenses while waiting for the long-term money from big retailers to come through. But that doesn’t mean it’s the best option for every company. A solution for some. Not all.
