The Accounting of Factoring
I understand the challenges of starting your own business and opening the doors for the first time. I also understand the challenges of being in business 1 year, then 2 years, 5 years, etc. Each subsequent year brings its own successes and challenges. At Factor Bid, our staff have experience in start-up companies, customer service, and all the business management pieces necessary to running a successful business. We are here to help you and be that FREE RESOURCE when you want to receive offers for your open accounts receivable invoices.
With that in mind, this article will focus on some basic accounting knowledge to help you understand how your accounts receivable invoice is able to be leveraged as cash. Let’s dive into the world of the BALANCE SHEET!
What is a balance sheet? A balance sheet verifies that a business’s financial records are, well, “balanced.” It tracks Assets, Liabilities, and Owner’s Equity. How does the balance sheet balance? That’s simple.
Assets = Liabilities + Owner’s Equity
The amount in the Assets column will always equal the amount in the Liabilities and Owner’s Equity column. If it doesn’t, there’s a mistake somewhere. Essentially, the balance sheet provides a quick snapshot of how your business is doing financially on any given day. It is usually calculated quarterly or at the end of the year. This is an important document when applying for grants, loans, submitting taxes, or looking for potential investors.
O.K., but what is an asset? This is an important question to ask, especially when considering to factor. An asset is anything tangible or intangible that can be owned or controlled to produce value and is held to have positive economic value. So, if your open accounts receivable invoice is considered an asset, it fits these three criteria.
Your open accounts receivable invoice:
- Can be owned or controlled
- Produces value
- Has positive economic worth
Look at the balance sheet above on the third line down, column 1. Do you see Accounts Receivable? This is also referred to as A/R. That $6,200 reported next to Accounts Receivable represents the amount of money this company has billed to someone for a product/service delivered but they are now awaiting payment from the customer. As Accounts Receivable Invoices are due within a short amount of time, usually within 30 days but no more than a year, it is considered an asset (as reflected by the column header).
As an Accounts Receivable Invoice is an asset, factor finance companies will pay cash for that invoice because it, 1.) Can be owned or controlled, 2.) Produces value, and 3.) Has positive economic growth. It is an asset. Just like a bank holding the title of your car (asset) until it is paid off, a factor financier will take ownership of an open Accounts Receivable Invoice (asset) until it is paid-off in full.
Who is willing to pay cash for my outstanding accounts receivable invoices? Factor financiers eagerly want to partner with businesses who produce accounts receivable invoices so they can purchase that asset at a discounted rate.
What if I am less than creditworthy? It does not matter. The credit ranking of interest to the factor financier is not you, but the person/business you are awaiting payment from. You see, the factor financier is only interested in the likelihood that your customer is going to pay, not you.
But what happens if a customer does NOT pay? Where does that amount go on the Balance Sheet? I am so glad you asked!
This, my friend, is called a bad debt expense. A bad debt expense is the amount of an outstanding accounts receivable invoice that has gone uncollected. Unfortunately, it also reflects the credit choices a business made when extending credit to their customers. In accounting, you can report this loss in one of two ways:
- Direct write off – The amount of the unpaid invoice is charged directly to bad debt expense. In order to maintain balance to the Balance Sheet, you debt the bad expense account and credit your accounts receivable account. It does not show a reduction in sales, but increases your expense.
- Allowance Method – A business estimates the amount of invoices they think will remain unpaid. So, if a business knows that, historically, 4% of their accounts receivable invoices go uncollected, they would subtract 4% from the Accounts Receivable amount and record the difference.
What does that have to do with my business, you may think to ask? Everything! Having a lot of bad debt expense can prohibit you from growing as a company, meeting your business needs, and even securing a loan or prospective investors.
When you factor finance your outstanding accounts receivable invoices, you are doing a few REALLY SMART things for your business:
- Limiting liability
- Keeping debt off the books
- Freeing up cash to grow
- Gaining a partner to help manage those invoices
How much does it cost you, really, to manage all those open accounts receivable invoices? When you partner with a factor financier, they own the invoice and manage it for you. What does that mean when you have 10, 20, 30, or more invoices you process a month: HUGE ADMINISTRATIVE SAVINGS while having ACCESS TO HUGE AMOUNTS OF CASH!
To learn more, click on the YouTube channel on the Factor Bid website. You can also submit an invoice and receive a few competitive offers from factor financiers who eagerly want your business and who work within your industry. Life is good with Factor Bid.
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