Are accounts receivables (AR) the lifeblood of a small business? Perhaps; but it definitely represents cash flow- or a lack of it. For businesses that utilize invoice-based payment methods for their customers, getting paid on time is essential to maintaining a steady cash flow and allows the business to have the working capital it needs to pay operating costs. Unfortunately, if cash flow gets bottled up, the business can face serious risks.
In an ideal world, there would be no aging accounts of course. But not all businesses can have a payment-at-time-of-service model. Therefore, it comes down to receivables. While the 30-day bucket of aging isn’t usually a problem, it’s when aging accounts move to 60-days, and, even more concerning, into the 90-day pile and beyond that businesses begin facing problems. All of these accounts represent unrealized cash flow; as the accounts move further from that 30-day pile, they are more likely to become lost income.
So, what can a small business do if it has immediate cash flow needs that are the result of unrealized receivables? First, realize that AR accounts are real assets, so don’t let them deteriorate. Instead, small businesses can consider a few options: AR factoring, invoice discounting, and AR outsourcing.
Accounts Receivable Factoring
Accounts Receivables factoring (or invoice factoring) is when a business sells its AR accounts (all or just a few select invoices) to a third-party company. Because the receivables are transferred to a third party, it is not considered a loan. The amount the receivables accounts are worth is not the face value, of course. The account amounts are based on the credit and payment histories of the clients (the ones that owe the business), as well as the industry and other considerations.
The “factoring” financial company will pay from 75-90 percent of the value of the invoices (receivables) as an advance, often within one or two business days. This is after an initial account has been created and the business has been verified by the factoring company. The business will be paid the remainder as the invoices are collected from the delinquent customers, minus a fee for performing the collection services. This fee generally ranges from 2-4 percent.
- Quick access to capital
- Acts as a line of credit against sales
- Does not appear on business credit reports
- Reduces value of invoices
- Interaction of third party collection services with clients
Sometimes called “discreet factoring,” invoice discounting is similar to factoring. The primary difference is that the small business retains control over its customer relationships: the invoices/AR are still theirs and they still need to collect them. As such, no outside company will contact their customers. This is because of another significant difference: invoice factoring is considered a loan with the small business's receivables acting as collateral.
When the business receives payment from its clients for those invoices, they pay back the financing company. There is traditionally a fixed monthly fee in addition to an interest rate for the loan, which depends on the business, its industry, and the client receivables. Both factoring and invoice discounting have the benefit of making most routine receivables into a next-day receipt of funds, with the cost being usually being three to four percent.
- Offers fast access to working capital
- Business retains control of receivables and all collections activity, meaning no third party interaction with customers
- Does not appear on business credit reports
- Reduces the value of invoices
- Generally only available for commercial invoices, not consumer retail
Outsourcing AR - Collections
Outsourcing accounts receivables can have two very different meanings. First (and most common), it is the selling of bad receivables to a collection agency. The second form of outsourced AR is similar to virtual CFO services, where an accountant or firm handles many day-to-day back-office functions for a small business.
Collection firms often have a negative reputation because of the work they do, but they do provide a valuable service to businesses. They offer expertise in following debt collection laws and practices and have the resources to find debtors if they have relocated. Costs for their services are either a flat fee or contingency and tend to be significantly higher than fees associated with factoring and discounting. As such, collections are best restricted to older receivables. Flat fee arrangements usually only offer the small business pennies on the dollar for their bad debts because they are usually quite difficult to collect and the agency is assuming all risk. Under contingency arrangements, the business might only have to give up 25-50 percent if the debt is collected.
Due in part to the costs and the interaction they will have with the clients of the small business, collection agencies should only be used as a last resort. If the business has tried consistently over the course of several months to collect on the debts and the loss of that client relationship is no longer a concern, collections are an appropriate choice.
- More effective at collecting old debt (90+ days)
- Frees up staff time
- High cost
- Can affect client relationships
Cash flow is an important part of running a business and, unfortunately, situations can arise where old debt affects your business. These solutions need to be carefully considered- especially if you want to maintain a relationship with your client. But they can provide upfront cash flow when the business needs it most, which can make all the difference to a business.