Have You Ever Considered Factoring As A Financing
Alternative?
Factoring or Accounts Receivable
Financing takes place when a business sells certain
accounts receivable invoices to a third party financing
company at a discount.
How It Works
Factoring can only take place once a
sale has been completed and goods or services have
changed hands. At this point, a bona fide accounts
receivable exists that can be sold to a receivable
financing company (Factor).
Outstanding accounts receivable will be considered on a
customer by customer basis to determine which
outstanding accounts are credit worthy.
Once an accounts receivable amount to be
financed is agreed to by both your business and the
financing company, your business is paid an advance of
somewhere between 70% and 95% of the value of the
invoice(s) being financed with payment normally received
within 24 hours of customer invoicing for approved
credit. When the invoice is paid in full to the
financing company, the balance, less the discount is
paid to you.
The discount will usually be +or- 3% for amounts up to
$100,000. Discounting rates can go down if the amount
financed on a monthly basis increases.
The financing company's choice of how much they are
prepared to factor is based on the credit worthiness of
the customer that owes the business money. The more
credit worthy customers included in the amount financed,
the higher the likelihood for getting an approval from
the financing company as more customer receivables
reduces the collection risk.
Normally, a factoring company can finance an outstanding
accounts receivable for up to 90 days. There are
situations where terms can be longer, but only on
larger, well established customer accounts.
Like every other type of commercial financing product,
there are several variations to the services provided by
this category of lender. Some companies provide
invoicing and collection services to their clients and
function as an extended billing and collections
department.
Other Factoring houses focus strictly on financing the
accounts receivable and leave billing and collection to
their business customer.
Factors may have very different processes and timelines
to qualify your application and may also have different
financing terms and conditions.
Therefore, it's important to find a financing company
that provides the pricing and related
accounts receivable financing services that best
fits your business situation and customer mix.
What Makes Factoring A Unique Form of Commercial
Financing?
Purpose for financing your accounts receivable is simply
to create more available working capital to operate your
business.
The financing application is based on the completed sale
of goods and services to a credit worthy customer. As a
company grows in size, it may become constricted in the
business it can generate because available equity and
debt financing are tied up in inventory and accounts
receivable.
Because customer credit provided to credit worthy
customers with a track record of solid repayment are
highly certain in nature, there is a financing value
that can be extracted via receivable financing.
Factoring is a unique in this way because the focus in
only on specific customer receivables and the assessment
of their ability to pay. Bank lines of credit and
working capital financing will provide a fixed level of
capital to a business and will normally take security
over all accounts receivable, inventory, and equipment
in the process.
However, as the business grows, so do the value of the
current assets. Yet, in many cases, the bank will not
proportionately increase the fixed level of capital
available even though the bank’s security position is
increasing. The business is then forced to invest all
its profits into inventory and working capital financing
to grow the business.
Unfortunately, this can still leave the business
scrambling to manage cash flow without losing sales.
This is where factoring comes in. As incremental sales
are created, the financing company has the ability to
finance a particular block of sales, expanding the
working capital in the process.
While banks do provide receivable financing services,
they tend to focus on larger, better established
companies with extremely low risk of default. This
creates a financing opportunity that factoring companies
fulfill.
But in order to provide the financing, factoring
companies will require your business bank to allow the
factor to have a first place security position on the
specific accounts receivable amounts being financed.
When Should You Use Factoring In Your Business
As we have discussed, the primary purpose of receivable
financing is to help you better manage your cash flow.
This type of financng is more expensive that other types
of working capital credit facilities and should be
utilized where appropriate.
And the most appropriate times are when you cannot
address cash flow shortages with lower cost financing
sources, and when the incremental cost of factoring is
less than the economic benefit you will receive by
increasing your available cash flow.
Let’s go through some examples.
You have a customer that you want to do more business
with, but the only way they will work with you is if you
give them longer terms, say 30 days to 60 days. But by
doing this, you now have to wait an extra 30 days to get
paid. Receivable financing would allow you to provide
longer terms to the customer and at the same time
continue to grow your business volume with that customer
without putting any of your other business at risk.
Another example would be that you get a sudden spike in
sales that you did not plan on and you don’t have enough
working capital to buy more inventories to fill the
sales. By factoring some of your existing accounts
receivable to generate cash, you will be able to make
the incremental sales and pocket the incremental gross
margin that exceeds the incremental cost of financing
part or all of your accounts receivable.
A Third example would be where you have a bit of a down
turn or slow time in your business cycle, and you need
cash to meet your short term operating demands, so you
factor a portion of your receivables to assist with the
cash flow crunch.
Regardless of the application, the decision to factor
should always make good economic sense. And, if you
utilize factoring properly to grow your business, it
should help create the size and profitability necessary
to acquire lower cost sources of financing in the
future.
It can be a great tool for your business, but you need
to use it wisely.
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