Factoring your accounts receivable to a third-party financing company (i.e., factor) will provide near-instant payment on your federal government invoices instead of waiting the typical 30 days or longer to receive payment. There are several things CFOs and CEOs alike should know before they consider factoring to cover cash flow issues.
What is factoring?
Accounts receivable financing, or factoring, is a type of asset-based lending that companies of all sizes, and across all industries, and is primarily used to improve cash flow. Factoring allows companies to sell their outstanding accounts receivable to a factor; a company that buys these receivables - and provides an immediate cash advance as a percentage of the total value of each factored invoice. This percentage typically ranges between 70 and 90 percent of the invoice total. Once the factoring company collects the full payment from your customers, it remits the remaining balance to your business after deducting its fees.
Government contractors, especially, can benefit from factoring. Any experienced federal contractor knows that the government tends to pay at the soonest when the invoices come due, or even a few days past the Net 30 due date. This wait time can create a dip in your liquidity and that is where factoring can help.
When to use Factoring
Specific instances in which you may consider factoring include:
- You are unable to obtain traditional bank financing due to several factors, including but not limited to the time you've been in business, your past creditworthiness (personal and business), and your company's financial standing. If your balance sheet reflects negative retained earnings, for example, then a traditional line of credit may not be in the offing and factoring is a good option.
- You need the money to make payroll, pay your subcontractors and consultants, or to cover other expenses, and you may not have the luxury of waiting for your customers to pay you.
While factoring means you will have to sacrifice some proceeds, which will be discussed below, it is a good option if your payment reputation and credit rating are threatened. - You do not want to damage client relationships by making collection calls.
The factoring company then takes over the responsibility of collecting payments from the business's customers so you don't have to play good cop or bad cop. A factoring company becomes a partner in helping to manage your receivables. - You are confident that your customers will eventually pay their bills.
Fortunately, when it comes to the federal government, its payment record is stellar and there is little risk involved. Even if you are a subcontractor, your prime is bound by the FAR to make timely payments, typically within 5 days of the receipt of payment from the federal government. For these reasons, you should use a non-recourse factor who will assume responsibility for invoices getting paid.
Downside of factoring
While factoring may on the surface sound like the ideal solution to solving your cash flow problems, the expected cash to be received is now owned by the factor, and you will receive a small percentage when the invoice is paid in full and your percentage will decrease based upon the DSO. The longer an invoice goes beyond its due date, the less residual proceeds from the original balance you will receive.
Factor fees are not dissimilar to paying the interest on a conventional loan and like the interest paid on a line of credit, such fees are unallowable per FAR 31.205. Ask your factor to total the fees and provide a cost estimate to factor a sample invoice.
We have seen many contractors through the years factor all of their invoices that are either issued directly to the federal government or a prime contractor. Oftentimes, it becomes difficult to transition away from factoring and into less costly methods of business financing. There is a bit of a stigma attached to factoring invoices for the long haul from your customer's point of view.
Conclusion
As you can see in the above guidance, factoring plays an important role for government contractors who need funds prior to invoices coming due.
The goal for every contractor, however, should be to eventually open a line of credit once the cash flow improves and then factoring can be relegated to a secondary source of financing when needed.
