If you are a licensed freight broker, you already know that you need to manage the flow of money from your customers to you, and ultimately to your carriers. This process is called cash flow, and it’s one of the main reasons new freight brokers fail. If you are a freight agent or an employee for a brokerage, you likely don’t have to even think about this too much. Regardless, let’s look at some basics of cash flowing a brokerage and how factoring comes into play.
Cash Flow Basics
In a perfect world, a broker would invoice their customer and receive prompt payment. They would then pay the carrier promptly as well, keeping the remaining money as profits. Everyone is happy, and the brokerage flourishes. The problem here is that customers don’t always pay quickly, but carriers expect to be paid within a reasonable amount of time. This creates the need for a broker to have cash on hand to ensure carriers are paid on time.
Most brokers arrange to pay their carriers in 21-30 days, and even offer a quick pay service allowing the carrier to be paid in as little as one day for a small fee. Although brokers might have a set payment schedule in place with their customers, the customers typically determine when they will pay an invoice. Some pay promptly such as within 30 days, but others might pay slower. It’s not uncommon for a customer to pay in 45 days.
Let’s look at a simple example. You invoice a customer for $1,000 and agree to pay the carrier $850. If your customer pays in 45 days, but you agree to pay the carrier in 30 days, you need to have the available funds to pay the carrier before you receive a single penny from your customer. In this example, you need to cover 15 days of payments if every single one of your loads looked like this. There are many reasons for you to receive payment even slower from a customer. Whether there was a claim involved, a dispute on the rate, or you were slow to send the invoice, that gap can steadily increase.
Most business professionals advise a company to maintain 3-6 months of revenue on hand as retained earnings. Retained earnings enable smooth cash flow, but not everyone has the available funds to do this. Retained earnings are also needed for other expenses such as salaries, rent, and other monthly business expenses that you incur to operate your brokerage (TMS, load boards, insurance, etc.).
Factoring is the process in which a company sells its receivables to another company in exchange for a fee. Brokers that use factoring companies can expect to pay around 3% on average to a factoring company to receive money faster. Let’s look at the same example and see how a factoring company would factor in, no pun intended!
Rather than invoicing your customer for $1,000, you would sell (factor) the invoice to a factoring company. After their 3% fee, your invoice is now worth $970. Further, the factoring company might only pay you 95% of the invoice up front, and the remaining 2% once the customer pays them. So now you have $950 available to pay your carrier on time. You will receive another $20 down the road, but that doesn’t directly help your cash flow in the current time.
Factoring can help newer brokers grow their company without the barrier of cash on hand standing in the way. The danger comes when a broker doesn’t have a high enough margin for factoring to be worth it. The example we used was a broker operating at a 15% margin, which quickly dropped to 10% (or 12%) once the factoring company was used. If a broker operates at a lower margin such as 8-10%, the factoring fees quickly eat into their profits.
Factoring companies aren’t a guarantee that you can extend credit to a shipper either. They will still do their due diligence in vetting a shipper out to ensure the shipper is likely to pay their invoice and pay it on time. If the shipper doesn’t pay, the broker is still liable to eat the lost revenue even though the factoring company was used.
We always recommend that brokers cash flow their business to maintain as much of a profitable business that they can. Factoring isn’t a bad thing, but you need to be aware of the costs and exposure that you still have as a broker if you decide to use one. Check out our episode on factoring where we talk with Mac Greene from Triumph Business Capital. We talk in more detail on this subject and give some tips and tricks to better manage your cash flow.