What is trade receivables financing? Cash flow problems can wreak havoc on even successful businesses. A single slow paying client could prevent you from being able to take on new clients and projects, or even force you to lay off employees. This can lead to stagnation in your business, and even to failure, ultimately.
Trade receivables financing can provide a solution to your liquidity problems, and help your company grow. How does this type of financial tool work, though? We’ll discuss what trade receivables financing is all about, how it works, and who can benefit from it below.
What Are Trade Receivables?
To understand how trade receivables financing works, we’ll first need to define what trade receivables are. This is just another name for accounts receivable – unpaid invoices that represent money owed to your business by your clients. They’re existing assets that your business owns. However, they’re also the source of the problem you’re experiencing with cash flow.
When a client is slow to pay, or takes full advantage of lengthy terms offered on invoice payment, it can cause cash flow problems within your business. This is particularly true for start-ups and small businesses, which often rely on payment from one client to take on a project for another client.
So, how can you leverage those assets and boost cash flow? You achieve that by financing your accounts receivable.
What Is Trade Receivables Financing?
There’s virtually no difference between trade receivables financing and other, better-known methods of raising capital. For instance, when you have old equipment that you no longer use, what do you do with it? Most business owners make the decision to sell that equipment, and realise an infusion of cash, rather than letting it sit unused.
Trade receivables financing is essentially the same concept, but instead of selling equipment or another physical asset, you’re selling an invoice. That invoice represents capital that belongs to your company, and selling it to a factoring company allows you to unlock the cash trapped within.
Once in hand, you can use that money for anything your business requires, from purchasing supplies and materials so you can take on the next job to paying employees or subcontractors, and even expanding your business if the opportunity presents itself.
Of course, you’ll need to know a bit more about how the process works to determine if this is a good option for your particular company and financial situation.
How Does Trade Receivables Financing Work?
Trade receivables financing might be similar to selling any other asset your business owns, but the process is not identical. While you might be able to sell a piece of unneeded equipment or surplus materials to another company in your industry, you’ll need to work with a factoring company to sell your invoices.
Factoring companies offer unique solutions to small and mid-sized businesses, and can provide you with cash for your invoices almost immediately. Essentially, the process works like this:
- You have an unpaid invoice from a client you trust, but that has not yet paid.
- You sell that invoice to the factoring company for an advance on the invoice total.
- The factoring company pays you the advance.
- You spend the advance to help support and grow your business.
- When your client pays the invoice, the factoring company pays you the remaining balance on the invoice total, minus a fee.
That’s the entire process – it’s not complicated, and it’s relatively straightforward. However, that doesn’t mean there are not things you’ll need to understand before finding a factoring company to work with.
Below, we’ll discuss some of the more important things you’ll need to learn.
We’ll start this discussion with the topic that bears most closely on your business growth – the amount of the advance. It’s tied directly to the amount of the invoice you’re selling. Some companies offer advances as low as 70% of the invoice total, but most firms will deliver between 80% and 90%. Some may even go as high as 98% of the invoice total.
The advance will be deposited in your account within 24 to 48 hours of the sale, in most cases. However, note that some companies do require that new clients wait four to five business days before the sale can be completed. Generally, this is to verify the creditworthiness of your client.
Now, it might seem like a higher advance amount is automatically a better idea, and it often is. However, you’ll need to compare the advance amount to the fees being charged by the factoring company for your trade receivables financing. In some cases, a lower advance amount and fewer fees will ultimately net you more of the invoice total than you would see if you were offered a high initial advance but then charged correspondingly high fees.
The Factoring Fee
The factoring fee is the cost of doing business with the company. It’s taken off the remaining balance on the invoice total after your client pays the bill, but before the factoring company pays you the balance remaining.
In most cases, the factoring fee charged will range between 1% and 5% of the invoice total. It’s also important to understand that the factoring fee is usually charged per month, so if the invoice you sell is for 90 days and your client takes the full term to pay, you’ll be charged the factoring fee three times. With a large invoice, that can quickly add up to a lot of money.
Contract or Spot Factoring?
Once you start comparing partners, you’ll find that some companies require you to sign a long-term contract with them, while others offer what’s called spot factoring. A long-term contract is not necessarily a bad thing, but it may not be the right fit for your needs. If any of the following are true for your business, then long-term contracts should be avoided:
- You work with clients on a one-time basis often
- You want to maintain as much control as possible over your accounts receivable
- You don’t need help with collections and billing
- You want the flexibility of being able to pick and choose which invoices you sell
- You don’t want to be locked into factoring all invoices from a particular client for a long period
If you’re not well-suited for a long-term contract, then spot factoring is the better option. Really, this is nothing more than the ability to sell invoices ad hoc, or as the need arises. You’re not locked into a contract with a factoring company, but you might pay higher factoring fees in the end.
You’ll quickly discover that not all factoring companies are created equal. We’re not speaking of quality or reputation, although both of those factors are important, but of specialisation or generalisation.
Generalist factoring companies ostensibly work with all comers. However, the problem here is that many industries vary wildly from one another, and if a factoring firm lacks experience in that particular area, it can cause problems. For instance, a factoring company with no experience in supporting transportation companies might find the speed with which invoices are turned over in the trucking sector daunting. The same thing applies to other industries, including:
- Research and development
For businesses in these areas, it’s important to work with a specialist. These factoring companies understand the ins and outs of your industry, and can often offer more affordable rates. They can also offer additional services that might increase their value to you, plus bring more benefits to your company. For example, a factoring company that specialises in the trucking sector can provide fuel advances, discount fuel cards and back office services to make trucking company owners’ lives easier.
Recourse or Nonrecourse Factoring?
In addition to the items we’ve touched on above, you’ll also need to understand the difference between recourse and nonrecourse factoring. This is an important consideration, as it will affect your overall experience, and will also dictate which clients’ invoices you decide to sell.
Recourse factoring is the most common in Canada. In this situation, you maintain responsibility if your client fails to pay the invoice on time or at all. If your client doesn’t pay, you’ll be required to repay the advance. Obviously, you should only factor invoices from clients that you trust completely.
Nonrecourse factoring is becoming more common, but it is not offered by all factoring companies. In this instance, the factoring company will be responsible if your client fails to pay, and you will not have to repay the advance. However, be aware that the fees for nonrecourse factoring are often quite a bit higher than those for recourse factoring.
You’ll also find a hybrid option available, called limited recourse. This falls halfway between recourse and nonrecourse factoring, and you have limited liability if your client does not pay the invoice. Limited recourse factoring is rarer than nonrecourse factoring, but some companies do offer it.
In addition to understanding the items above, you also need to choose the right factoring company for trade receivables financing. They differ in more ways than just generalist or specialist firms, and the advance amounts offered. We’ll delve into vetting partners in the next section.
Vetting Potential Factoring Companies
With the growing number of factoring companies in Canada, it has become more important than ever before that you’re able to make an informed choice here. There are several criteria on which you should base your decision, and we’ll cover some of the most relevant.
Additional Fees and Charges
Some factoring companies offering trade receivables financing are pretty transparent when it come to the fees and charges assessed. Others are not. Make sure to study the contract agreement before signing. Look for any additional fees beyond the factoring fee. Each additional fee reduces the financial benefits of factoring to your company, and in a worst-case scenario, might make signing that contract a bad idea.
Once you sell that invoice, the factoring company will be the one communicating with your client. It’s important to make sure they provide excellent customer service and do not harass clients. This can ruin relationships that you’ve worked very hard to establish, and drive a permanent wedge between you and the client in question.
It can be a challenge to determine a factoring company’s client interaction habits and collection methods, but it’s important that you do so. If necessary, contact current or past clients of the company and speak with them about their experience and how the factoring firm treated their customers.
Reputation and History
One of the first things you should learn about any potential factoring partner you’re considering for trade receivables financing is how long they’ve been in business. A history that spans many years shows that the company has what it takes to stay in business. You’ll also need to check their reputation. This goes beyond how they interact with your clients during billing or collections, and touches on how they treat their clients (you, in this case). Obviously, you want to work with a company with a reputation for transparency, honesty, integrity and low fees.
Conducting research and doing your due diligence on factoring companies can be difficult. After all, you’re a business owner with a company of your own to run. Every minute spent researching and comparing potential partners is one more minute you’re not spending building your business. We can help.
The Assistance You Need
When it comes to finding a partner for trade receivables financing, we have years of experience. We’ve built a reputation for delivering vital, accurate assistance, and pairing our clients with the right factoring company for them. Whether you need recourse or nonrecourse factoring, want to take advantage of spot factoring, or have no problem signing a long-term contract, we can help. We invite you to take advantage of the free consultation with one of our factoring specialists and learn how simple it can be to grow your business.