Finance Blog Factoring and your business
Factoring and your business
Written by Larry Johnson Friday, 06 November 2009 16:34
What is Factoring?
The term "factoring" is derived from the Latin "factare" which means "to make it happen"! And this is essentially what it does ...
Factoring is known by many names. These include "cash for receivables," "discounting receivables" or "purchasing receivables." By whatever name it is known, it means that a business accounts receivable are converted into immediate cash by the outright purchase of its A/R or invoices, at a discount by a factoring company.
Many businesses have expenses on a two-week or monthly basis and find it difficult to wait the 30-90 days or longer for their customers to pay them for goods sold and delivered or services rendered. Factoring addresses the cash flow gap. Most small businesses need cash NOW for payroll, taxes, operating expenses, etc.
A common example of factoring are the use of credit cards. The credit card company guarantees payment of the purchase to the seller. They are purchasing an invoice from the merchant (the seller) at a discount, and giving the merchant immediate cash.
A company using factoring is selling its receivables, which is an asset, and not borrowing against them, so they are not creating debt. It is a type of revolving credit, in that funds supplied are short-term since invoices are usually paid within 90 days.
Factors dont operate under the same restrictions as banks they are not bound by the same regulations, so they can be more flexible in their credit granting standards and take greater risks. They are an alternative that should be considered.
Factoring is not a loan and is not based on the ability to repay. The length of time in business is usually not a consideration. The debt to equity ratio is not a consideration. Instead, it is based on the ability of a clients customers to pay what they owe. Once a factor purchases the receivable (invoice), they assume the responsibility for its collection.
The client is obligated to notify each of its customers to pay the factor directly. There are ways for the Factor to limit your client's awareness of your use of their service.
The Factor is responsible for accounts receivable management functions, such as credit investigation, accounting and bookkeeping. As compensation for these activities, the factor is paid a discount fee. The Factor purchases the receivables at a discount.
Depending on the size and quality of the client receivables, non-recourse may be negotiated and clients need not be notified that a Factor is involved.
Once a factoring contract is entered into, the borrower submits all his orders to the factor for credit approval before shipping. The factors credit department becomes the credit department of the borrower. If the order is approved, the borrower is then entitled to a percentage of the proceeds (BFA can go as high as 90%), with the remainder retained by the factor as a reserve against loss from complaints and returns. Usually, the Factor will settle the account each month and pay the borrower the proceeds due, less interest, commissions, and cash discounts. After this the company is not concerned about collection.
Who Needs Factoring?
- Businesses that cannot get conventional financing.
- Any business needing additional operating capital.
- Businesses that want to expand and need a cash flow injection.
- Businesses with tax liens or problems.
- Businesses working through or operating under bankruptcy protection.
Benefits of Factoring
- Increase working capital by establishing an additional, ongoing source of cash.
- Increase cash turnover and pay bills, taxes, etc., on time.
- Get cash for operating expenses when they need it.
- Get cash when they cant get financing elsewhere.
- Avoid giving up equity or control, as they would in traditional financing.
- Protect and improve their credit rating.
- Avoid long-term debt.
- Avoid repayment of debt at inopportune time.
- Take advantage of trade discounts by paying up-front for supplies, equipment, etc.
- Take advantage of other spur-of-the-moment opportunities requiring cash.