When factoring receivables can help SMEs improve cash flow

Selling receivables to a financial institution at a discount in exchange for immediate funds may alleviate cash flow problems.
By Charles R. Pryor, Ph.D.; Nicholas C. Lynch, Ph.D.; and Stephen S. Gray, DBA

When factoring receivables can help SMEs improve cash flow

There are trillions of dollars of trade credit outstanding in the U.S. economy today, and at least a portion of it is undoubtedly creating an unnecessary cash flow burden for many small- to medium-size entities (SMEs). Giving the customer 30 days to pay has been a common practice in many industries for a long time, but since the 2008 financial crisis, many SMEs throughout the supply chain have faced increasing pressure to extend payment terms to 45, 60, 90, or even 120 days, which would significantly increase cash conversion cycles. As the balance in receivables grows, SMEs must invest more cash in working capital to fund operations, prepare for emergency expenditures, and position themselves to take advantage of emerging growth opportunities.

SMEs with significant amounts of trade receivables may be able to effectively alleviate cash flow problems by factoring those receivables. However, factoring can be a costly form of financing, and many financial advisers do not recommend it because they believe it is too expensive.


While many large, successful companies routinely factor receivables, SMEs may be unfamiliar with this financing option. In a factoring arrangement, a firm sells its receivables to a financial institution (a factor) for cash, but at a discounted price. The factor takes over collection responsibilities and provides cash upfront, typically equivalent to 70% to 90% of the value of the receivables, and remits the balance minus fees upon collection.

The factor's fee will be a small percentage of the receivables factored, which covers the factor's administrative costs, the cost of collection services, and a financing charge on the amount of cash advanced by the factor. Fees can be lowered by factoring with recourse because it lowers the risk borne by the factor. "Recourse" means that a portion of cash advances may have to be repaid to the factor if collection efforts are unsuccessful.

Some factors may be unwilling to buy certain receivables, which reduces the value of factoring because exclusions can significantly reduce the resulting cash proceeds. For example, factors often exclude low-quality receivables based on their age. Many factors also do not accept receivables from export companies because of the additional time and expertise required to facilitate cross-border transactions. Nevertheless, many SMEs may find it worthwhile to invest the time needed to find the right factor for them.


Individual circumstances must be considered when a company evaluates factoring as a potential form of financing. Not all SMEs can benefit from factoring arrangements. Some of the characteristics to consider in determining whether selling receivables is worthy of consideration include:

Service providers

The truth is that factoring is expensive. Conventional loans collateralized by tangible assets, such as inventory, are often a cheaper financing alternative. However, tangible assets are not always available to secure a conventional loan. For example, service providers do not have inventory to serve as collateral. Furthermore, many service firms are not capital-intensive and therefore do not have much property, plant, and equipment (PP&E). Even those entities with significant PP&E may lease those assets.

COD-only sales

Entities that do not sell on credit might be able to attract new customers at a faster rate by offering customers more flexible payment terms, and factoring could mitigate fears about the cash flow implications of carrying large receivables balances. Even existing customers might order in larger quantities if not required to pay cash on delivery (COD), which would offset the cost of factoring by reducing the costs of freight and order processing.

Incongruent payment terms

Businesses that offer longer payment terms to their customers than they receive from their suppliers may be in a perpetual cash crunch. When SMEs routinely attempt to strategically time payments to suppliers so that they coincide with expected payments from customers, it is a good indication that factoring might prove useful. Furthermore, if factoring allows SMEs to take advantage of purchase discounts offered for paying suppliers more promptly, it will offset the cost of factoring.


Employing year-round collections staff is costly and may be unnecessary for firms with high levels of receivables during only a portion of the year. Seasonal businesses may be able to lower overhead costs by using factoring to outsource the collections function. The cost of factoring would be offset by the savings from outsourcing, and the collections expertise of the factor may significantly increase receivables turnover.

High growth

Growing businesses face increasing operating costs and require increasing levels of investment in working capital. The problem is that while cash outflows for additional staff, inventory, etc., are increasing to meet projected sales growth, cash inflows reflect sales levels over the past few months. Factoring can mitigate such growing pains by shortening the cash conversion cycle.

Credit risk

It is common for new businesses to experience negative cash flow from operations. New businesses that aren't yet profitable or businesses with a high debt-to-income ratio pose significant default risk. Consequently, they may not qualify for conventional loans or sufficient lines of credit to support operations. In cases like these, factoring can be used to reduce the likelihood of cash shortfalls because the ability to finance with receivables does not depend on the credit worthiness of the SME but rather the credit worthiness of its customers.

Low-quality receivables

If an SME's average days sales in receivables exceeds the terms of sale or if the balance in receivables is growing at a faster rate than sales, it may indicate that the SME lacks the expertise needed to effectively manage credit risk. Although factors often will not accept low-quality receivables, it is never too late for firms with poor credit management skills to start benefiting from the expertise of a factor. SMEs may even be able to guarantee the acceptability of future receivables by implementing a credit-approval process approved by the factor.

Government contracts

Government contracts often result in high-quality receivables, but even a profitable firm will not survive if cash comes in too late to meet its obligations. Doctors in some states have waited as long as a year to receive insurance payments for health services provided to government workers, but once in place, a factoring arrangement could shorten the wait to mere hours.


Not all factors accept receivables from export companies, but those that do offer more than increased liquidity. They also offer a level of expertise in dealing with foreign customers that the typical SME is unlikely to possess. Foreign languages, accounting rules, business customs, and legal environments can be extremely treacherous to navigate. Consequently, relying on an experienced factor to facilitate transactions around the globe could have major strategic advantages.


Some of the firm characteristics indicating that factoring might not be right for an SME are often just corollaries of those that suggest otherwise. For example, businesses with excellent credit management practices might be wasting money by factoring. Some additional considerations that may negate the potential cash flow benefits of factoring include:

Customer behavior

Factoring the receivables of customers who pay reliably and quickly is probably not worth the cost.

Competitive strategy

SMEs following a low-cost leadership strategy may not be able to factor and maintain profitability because margins are too thin. On the other hand, it is possible that factoring could prove useful even for low-cost leaders. However, making that determination requires a careful analysis of the firm's cost structure. Entities operating with significant fixed costs may be able to dramatically increase sales without proportionate increases in fixed overhead, which would increase average profit margins — perhaps enough to cover the cost of factoring.


Large, successful businesses are more likely than SMEs to generate enough cash to simultaneously fund operations, investment, and even debt repayments. In other words, mature businesses are less likely to experience a cash crisis that factoring might mitigate. Nevertheless, many large businesses still choose to finance using their receivables for other reasons.


The most obvious benefit of factoring is the improved cash flow that results from converting receivables into cash almost immediately, but there are less obvious benefits as well. Factoring allows businesses lacking in-house credit management expertise to benefit from the expertise of the factor. Experienced factors will quickly be able to determine whom to talk to about getting paid, track payment cycles, and implement follow-up procedures to ensure that payment expectations are met. Factors may also be willing to provide useful statistical reports regarding their collection activities. Furthermore, many small business owners view collections as an irritation but may be unaware that they can outsource that business function to a factor. Doing so would allow them to focus on operations instead of spending time chasing customers for money, which could damage customer relationships if handled improperly.

Another potential advantage of factoring over most other forms of financing is that it isn't dependent on the SME's credit rating. Instead, it is tied to the quality of receivables — the creditworthiness of the SME's customers.

Lastly, the availability of cash is inextricably linked to the company's performance. Factoring provides higher and higher levels of cash with continued receivables growth, which is advantageous for growing firms because sustained sales growth requires an ever-increasing amount of cash committed to working capital. However, it must be noted that the reverse is also true. As sales stagnate or decline, cash flow from factoring arrangements also declines when the need for cash may be most keenly felt. However, even this could be viewed as advantageous because the cash crunch may focus management's attention more quickly on the problems causing the sales decline (see the sidebar, "How to Get Started With Factoring").


The characteristics of the business are not the only determinant of whether factoring is right for an SME. Two ubiquitous criticisms of factoring must always be considered. The reflexive objection held by some advisers is that factoring is expensive, which is true. Annualized rates could be in single digits but could also be in excess of 20%, depending on the quality of the receivables and the expected time required for collection. Fees may appear small at first glance, but if the factor charges a 1% fee for advancing cash that would have been collected in 30 days anyway, the true rate in annual terms is closer to 12%.

A second objection to factoring is that it has the potential to create a bad impression with the SME's customers. This risk exists because the factor, an unrelated third party in the eyes of the SME's customer, takes over collections, which may create the impression with customers that the SME is having money problems. More important is the risk to customer relationships if the customer is frustrated by a perceived breakdown in communications with the SME. For example, consider how customers may feel when dealing with a factor over billing disputes. The reputational risk to the SME is difficult to quantify but is not insignificant. Nevertheless, the advantages of factoring often outweigh any potential disadvantages.

Be aware that factors will normally file a UCC (Uniform Commercial Code) security interest on the SME before providing it with funds. The UCC is a state law often used by a creditor to attach collateral to loans in the same way that real estate is used to collateralize mortgages. This protects the factor's interest in the receivables if the SME enters bankruptcy. However, it also prevents the SME from refinancing with other factors or financial institutions until the filing is removed, which the factor can easily do at the conclusion of the factoring contract. Before signing any security agreement, the SME should make sure the collateral is accurately described.

SMEs may want the ability to respond to changing circumstances if they find that factoring is no longer right for them, so they should be aware that most factoring agreements are term contracts for periods ranging from six to 24 months. Know what the penalties are for leaving the contract early, assuming that it is possible.


Even if it is a temporary solution, factoring may offer a better remedy for cash-strapped businesses than credit cards, which are far too often used as a source of quick cash. Factoring certainly should not be dismissed without careful consideration because in addition to offering quick cash, factoring provides expertise in cash flow and credit management that is often lacking in a typical SME. To illustrate what an asset this expertise can be, consider the extra sales required to recover the loss from a bad debt. For any business with a net profit margin of 5%, recovering a $1,000 loss due to uncollectible accounts takes an additional $20,000 in sales.

Whether or not they are factoring, business owners should know that the quality of their receivables can mean the difference between success and failure. Consequently, the most important long-run advice for an SME regarding receivables is to foster a relationship between the sales and collections departments that is collaborative — not adversarial — because effective risk management is a collective responsibility.

How to get started with factoring

Getting started with factoring is not complicated for a small business that decides after careful consideration that the benefits of the strategy outweigh the disadvantages.

The first step is to locate a suitable factor, and perhaps the easiest way to do that is with an internet search. For instance, the International Factoring Association maintains an online member directory (available at factoring.org) that you can search using multiple criteria, including geographic location and industry specialization.

When interviewing a potential factor, be sure to ask these questions:

  • How long have you been in business?
  • Do you have experience in my industry?
  • Do contracts include a minimum amount of receivables?
  • What is the discount rate and what additional fees are there?
  • How will you contact my customers?

About the authors

Charles R. Pryor, Ph.D., is a professor of accountancy, and Stephen S. Gray, DBA, is an assistant professor of finance, both at Western Illinois University in Macomb, Ill. Nicholas C. Lynch, Ph.D., is a professor of accountancy at California State University, Chico.

To comment on this article or to suggest an idea for another article, contact Ken Tysiac, the JofA's editorial director, at Kenneth.Tysiac@aicpa-cima.com.

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