Factoring plays an important role for government contractors who navigate between the worlds of government and business. Here are several things every CEO and government contractor should know before they use factoring to cover cash flow problems.
Business owners often turn to accounts receivables factoring to fill in the gaps of a cash flow that has temporarily run dry due to forces outside their control. While factoring is a viable solution to making payroll or paying your vendors on time, using the proceeds recklessly can put your company at risk. This risk occurs when early receipt of expected cash creates the illusion of having excess cash, when in fact, you are using a delicate financing method that must be completely understood.
This article will get you up to speed on what you need to know to use factoring responsibly.
What is factoring?
Accounts receivable financing, or factoring, is a type of asset-based lending that companies of all sizes, and across all industries, use to deal with fluctuations in cash flow. Factoring allows companies to "sell" their accounts receivable to a factor - a company that buys these receivables in order to improve their short-term cash balance.
Government contractors, especially, can benefit from factoring since they operate in both the government and the business world. Any experienced contractor knows that the government tends to pay at the soonest when the invoices come due, or a little while past the due date. However, as a business, you need to pay employees and vendors on time. Sometimes, this discrepancy can create a snag in your finances and that is where factoring can help.
When to use factoring
Specific instances in which you may consider factoring include:
1. You need the money for business continuity.
If you need unpaid funds to make payroll, to keep subcontractors happy, or to cover other expenses, you may not have the luxury of waiting for your clients to get around to paying you. While factoring means you will have to sacrifice some earnings, which will be discussed below, it is a good option if your business' livelihood is threatened.
2. You don't want to damage client relationships.
Other than an occasional late payment, if you have positive relationships with your clients, you probably don't want to threaten them with legal action or collections. A better, more neutral, course of action might be to inform them that invoices that aren't paid by a certain date will be sold to a factoring agency as a standard procedure.
3. You are confident that your clients will eventually pay their bills.
Factoring should only be used if you are certain your clients will pay because you will have to pay back the cash advance eventually. If the factor is not successful in receiving payment within the invoice terms, the factor's fees will continue to escalate on the unpaid balances.
The Factoring Company
Factoring can help protect your credit rating when your cash outflow temporarily exceeds your receivables, but a factoring company does more than just provide funds. A factoring company becomes a partner in helping to manage your receivables, so they are vested in the future performance of your customer base. When you submit a client for factoring, the factor analyzes them to be sure they are creditworthy. This added benefit is like having your own in-house credit department.
Risks of factoring
While factoring may sound like the ideal solution to solving your cash flow problems, you must proceed with caution. Often, businesses make the mistake of thinking of upfront funds received from the factor as a windfall instead of a line of credit.
When you hire a factoring company, the expected cash to be received is now owned by the factor, and you will receive only a small percentage of the total balance when the invoice is paid in full.
The factor will finance a percentage of the accounts receivable balance, perhaps 80 to 85 percent of the balance. The remainder of the payment will become a settlement payment and the factor will remit an amount less than the balance due for factor fees. This results in an unrecoverable amount, which you must pay to enjoy the benefits of doing business with a factoring company. It's like paying the interest on a conventional loan; this is the cost your business incurs for obtaining the financing.
Questions to ask the Factor
Is the factoring full-recourse or non-recourse? Non-recourse factors in the government contracting space tend to be less expensive given the isolation of the receivable’s credit risk.
Are personal guarantees required? Full-recourse factors will require a personal guarantee, while non-recourse factors do not.
What is the all-in effective interest rate? Ask your factor to total the fees and provide a cost estimate to factor one of your past invoices as an example.
Are there minimum terms or termination fees?
The Bottom Line
As you can see, factoring plays an important role for government contractors who navigate between the worlds of government and business. Use it to shield your business from the harm a sudden cash flow problem can inflict. However, being disciplined is the key to using factoring wisely. Always think of the funds received as a quick-turnaround temporary loan to meet cash flow spikes, and nothing more.