With the rise of alternative financing and lending options as well as the persistence (though drop) of traditional lending options, small businesses today have a lot of options to choose from when considering funding. As alternative financing options such as accounts receivable factoring continue to rise in popularity, there still remains some confusion regarding how they work, particularly with regard to their accounting practices and procedures.
Factoring Services Are Sometimes Misunderstood
Invoice factoring is not a loan though sometimes it is confused as being one. Invoice factoring or factoring receivables is what is known as an off-balance sheet financing method. To those who are unfamiliar with this term, it may cause concern because it was once associated with the Enron scandal of 2001. Despite this infamous misuse of off-balance sheet financing, the practice is indeed a legit, though sometimes misused, accounting practice.
Avoid New Debt with Invoice Factoring
Many businesses that opt for factoring accounts receivables do so to avoid taking on new debt because they have high debt-to-equity ratios. Instead, they want to use their existing accounts receivables to get the cash they need to improve cash flow, cover the costs of a major new purchase or pay their vendors on time. In this way, the company uses its existing account receivables to get cash, and it serves as a transaction onto itself. As such it is not a term loan or new debt and therefore does not go on the balance sheet or financial statement.
Factoring Receivables Uses Your Invoices as Collateral
Off-balance sheet financing can get itself into trouble when it is used to hide real debt and give the impression to investors that the company has less debt than it actually has. The Sarbanes-Oxley Act was in part created to prevent future misuse of off-balance sheet financing methods such as hiding debt in special purpose entities.
Though there are a number of legitimate off-balance sheet financing uses, such as invoice factoring, operating lease, sale/leaseback financing, asset based financing, inventory financing and more, the practice has gotten a bad rap in some circles because it has been abused. Yet new regulations have been put in place to better prevent this misuse from happening again.