Receivables factoring is a measure used by small businesses to increase liquidity overnight. Factoring is the sale of accounts receivable to a third party. Factored at a discount, purchasing parties generally offer terms to factoring agreements, including servicing of the accounts during a stated period, as well as buy at the end of the contract. The bargained for exchange of cash for outstanding monies owed on a seller’s accounts receivables.
Factoring has traditionally allowed small businesses to obtain the cash required to fulfill immediate accounts payable and other cash flow expenses. Reduction of the size of the cash balances owed, often enables a merchant or other small business to grow inventory and increase promotion. The use of cash from factoring when applied to accounts payable of core operations such as payroll ensures that a small business will be sustainable during limited receipt on accounts.
One of the best and easiest methods of advancing funds for business payables and other expenses, factoring of receivables values invoiced sales. If a small business seeks to make 70% to 85% on the purchase price of receivables on account, factoring is a solution to cash flow constraints. Third parties purchasing factored accounts, pay the balance on those accounts in exchange for commission and other charges. Some factoring services only pay on accounts for business owners at time of maturity, in exchange for similar fees. Business owners interested in adding to liquidity should be careful about this distinction.
Application of GAAP to Factored Accounts
Generally Accepted Accounted Principles (GAAP) rules and standards are applied in accounting practices used in factoring of accounts receivables. Rules outlined in the Statement of Financial Accounting Standards No. 140 cites that factoring of receivables is consistent to financial loan transaction, and are subject to collateral qualifications. Liability in connection with this rule states that the buyer will have no recourse without terms and conditions to future resale. In sum, GAAP principles control risk of liability to purchasers of factored accounts receivables, where terms are cited.
Some third party buyers of factored accounts receivables will allow a merchant or small business owner to service clients, accounts and all operations corresponding to the entitlement of those agreements to contract term. Full-service debt factoring is an optimum financial instrument for small business owners for this reason. Most businesses starting out have limited access to credit. Invoices and accounts receivables offer debt collateral in exchange for much needed cash flow.
The Factoring of Accounts Receivables
Calculation of factoring measures rate of return on proceeds invested in production exceed costs associated with the factoring of the receivables. Cash lending based on the projected return a firm will earn on an investment in production, and the expense of factoring in relation to liquidity hand. Factoring is a short term solution to cash flow fluctuation.
Determination of factoring to cover existing cash constraints is met with a cash balance strategy, based on liquidity requirements. Variability in cash flow determines the size of the required cash balance a small business must retain on hand. Use of a factoring mechanism will ensure that cash flow variability accounts for the extent of change to cash flow, and also length of time that cash can stay at a below average level until it becomes risky for the business.
Balancing Opportunity Cost
The demand for cash that might stimulate factoring of accounts receivables for sale to a third party has much to do with existing cash balances, and near future obligations to debt and operations expenses. Factoring accounts decreases the threat of less reliable stop gap measures; establishing a good faith contract for return on investment. Merchants and other small business owners using factoring to offset expenses look to opportunity costs proportional to obligations and risk.
Physical inventory is perhaps the number one reason small businesses use factoring to convert monies owed to liquidity. The demand for prepaid inventory or near future payment on services to supply business operations with resources in order to sustain sales is often critical. Factoring of accounts receivables can make a significant difference in the sustainable future of a small business, responsive to clients, yet in a cash crunch.