The world of corporate finance has many strategies, concepts, and methods of making money and running smoothly. Some are more effective than others, and some aren’t effective at all. Yet they are still used. Some of these practices include factoring and risk insurance. In some rare cases these practices can be useful. But more often than not they are a temporary fix for a problem. They only create more expenses for your company.
Let’s be more specific by explaining what these two practices really are.
We’ll begin with factoring. This is when a company sells its accounts receivables to a financing company to receive a percentage of their value in cash. You receive immediate capital, but overall less money than you would have if you haven’t gone down this road. It’s as if you had a car you could sell for 10,000$, but because you needed the money right away, you sold it for only 7,000$. Long story short, you are trading away your valuables for less than they are worth and essentially cheating yourself out of money.
Beyond that, factoring has many other disadvantages. Customers that were paying for those accounts receivables will be notified when factoring takes place. It warns them about your cash flow troubles and may create some amount of stigma, assuming that your company is going downhill financially. And of course, besides not making as much money from the accounts receivables as you could have in the first place, factoring them is still more expensive than most loans. The financing company you sell the accounts receivables to often charge prime rate interest on cash advances. It creates a total of large amounts of annual interest that could be crippling for your business.
As for risk insurance, it is simply insurance offered to high risk individuals that are more likely to need that insurance than others. For obvious reasons, this is something with very high potential to be painfully expensive.
On one hand you are receiving more money by offering insurance to a wider range of customers. But on the other hand, you are drastically increasing your chances of having to pay significant amounts of money for some sort of accident. Take auto insurance as an example. Imagine that you offer insurance to an individual that has crashed their car 4 times in the past five years. That individual is paying you an insurance premium. But what is the likelihood that you will be paying for yet another crash anytime soon?
In that sense, risk insurance is fairly simple, and it’s fairly simple to see why it is a bad idea.
Of course, some would say that making such assumptions is foolish. Just because that driver has crashed so many times in the past does not necessarily mean he will again. And this is true. Probability is nothing more than a hypothesis really, and one that can’t even be proven until the incident actually happens. That said, the majority of corporate finance operates on predictions. The stock market itself operates almost completely on predictions and guesses. Avoiding high risk situations is just a way for companies to stay safe, and avoid putting themselves in a complicated situation without suitable payoff.
And as we all know, the idea behind insurance is to provide it to individuals who will need it the least. Insurance companies receive a lot of money from their clients, but as soon as that insurance actually becomes needed, they are suddenly losing big bucks. This system of operation may not be necessarily fair, but it is certainly the most financially sustainable. It’s just like lending. You lend money to individuals you are fairly certain will pay it back. It’s just good business practice.
Of course, it’s important to understand that every financial strategy has some merit. If not, no one would have used them in the first place. As mentioned previously, business factoring can be useful in the sense that it provides immediate capital in an emergency. But in the long run, it is the only advantage it offers. And in every other way, it is a hindrance. It’s important to acknowledge that just because a course of action has benefits does not mean it has an overall benefit for your company.
That said, it is up to each individual company to determine whether or not certain courses of action are right for them. Even if those decisions aren’t the best for everyone.