Odunayo Adeniji |
Odunayo Adeniji
odunjoy.adeniji@gmail.com
Every business entity aims to offer their goods or services to customers for a profit. However, not all customers will pay cash for transactional exchanges. Goods and services are sometimes offered on credit, i.e. on a “buy now and pay later” basis. So, debtors may form an indispensable part of many business processes.
Accounts Receivable, also known as debt appear as a current asset in a business’s Statement of Financial Position (Balance Sheet). Current assets are expected to be converted to cash within a period of one year. Examples of current assets are cash and cash equivalents, accounts receivable (also known as debtors), inventory, etc. The ability of accounts receivable to be easily convertible to cash is best for businesses to remain liquid and manage its cash flow efficiently.
Cash Flow
Cash flow is the total amount of money that flows in and out of a business or an entity over a specific time period (e.g. monthly or annually). The cash flow reveals how liquid an entity is per time. Liquidity impacts on how an organization meets up with its financial obligations as at when due.
When a business entity offer goods or services to customers on credit, its funds are tied up with such customers until they pay up. Each credit sale creates a financial gap, limiting a business’s access to immediate working capital needed to keep operating.
Most Small and Medium Enterprises (SMEs) are unable to raise their level and quality of production due to inadequate financing. Opportunities for business advancement may be lost due to stifled cash flow held as debtors. A high amount of accounts receivable is a threat to the going-concern of any business venture.
At such times when a company needs to enhance its liquidity, it could either wait for its debtors to pay up any outstanding sales invoice, or sell such to a debt factoring company.
Debt Factoring
Debt factoring, also known as Invoice factoring is an external source of short-term finance available to a company. It offers a business the option of raising immediate cash by selling its outstanding sale invoices to a third party (a factor) who advances part of the face value of the invoices up front at a discount.
How Factoring Works
A company may offer goods or services to a customer (debtor) on credit for which payment would be made at a future date. When and how the debt will be settled is agreed on and spelt out in the sales credit terms. The company then raises an invoice to this effect. A copy of the invoice detail is thereafter sent to a debt factor, who pays an initially agreed percentage (cash advance, often between 80% and 90%) of the invoice’s face value to the business within 2days.
The debt factor then takes on the responsibility of invoice debt collection from the customer, freeing the company of the duty of debtor chasing. Once the debtor pays up the face value of the invoice in full, the factor pays the remaining percentage balance on the invoice to the company after deducting its (factor) fee or commission for the service(s) rendered.
Rather than losing loyal customers who are slow paying, a business has the financing option of trading its accounts receivable to a factor. Doing this avails the business instant access to working capital to harness further opportunities for growth and expansion that could have been missed as a result of deferred payment for goods and services offered to clients on credit.
The Cost of Factoring
Adopting accounts receivable factoring as a short-term finance option for a business is not without any cost implication. Therefore, it is pertinent that any company taking on this option understands the cost that may be attached to securing the services of a debt factor.
A debt factoring company may charge its service fee or commission based on several factors presented to it, which may include some of the following:
- The creditworthiness of the customer
- The amount and volume of the accounts receivable of the client firm.
- The length of time it will take the customer/debtor to pay up.
- The industry within which the business operates.
Usually, debt factoring companies charge a fee that range between 1% and 5% for its service to a client. Volume discounts are sometimes offered to a company with a high volume of monthly receivables.
Benefits of Debt Factoring
Invoice factoring is beneficial to companies in a variety of ways. Some of these benefits are highlighted below.
- A company may acquire short-term finance for its operations without taking on any more debts/liabilities than it may already have in its capital structure.
- Accounts receivable are easily converted to cash for immediate use. That is, debts due in the future can be turned into cash now.
- With the factor acting in the capacity of a debt collector, the company can focus on research and innovations, providing and selling more goods and services, rather than chasing its debtors for payment.
- Debt collection period agreed to by the factor is usually shorter than such allowed by businesses. Shorter collection period will equal improved cash flow from credit sales.
- Debt factors do not require any collateral to advance cash for sales invoices as is required when taking a bank loan.
Limitations
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The major limitation is that the customers (debtors) will not have to deal with a third party (the factoring company), collecting debt on behalf of the company. This could impair the relationship already formed between the company and its customer due to third party involvement in debt collection.
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Another drawback is that the company does not get to recover the full value of its receivables because the factor would have taken a cut from the total receivables value. Impliedly, there is a reduction in the profit a company would have made assuming it does not have to pay the factoring company a commission or fee.
Conclusion
It is generally onerous for small and medium enterprises (SMEs) to raise funds essential to grow their businesses. Debt factoring therefore offers a suitable solution for short-term financing for businesses with trustworthy customers, to raise short-term funds to drive their business operations.
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