Factoring is a form of financing in which a business sells its receivables to a third party or "factor company" at a discounted price. Under this arrangement, a factor company agrees to provide financing and other services to the selling business in return for interest and fees on the money that they advanced against the seller's accounts receivables. Businesses in need of cash can thus secure about 80 percent of their accounts receivables' face value. In rare cases, a higher percentage can be secured, but in most instances 20 percent of the value of the accounts receivable is held in reserve until the accounts are collected.
Factoring is a tool used by many established firms to avoid the sorts of cash flow problems that arise because of a customer's slow payment patterns. Economic downturns are often accompanied by an elongating of the average invoice payment time. Cash is the lifeblood of a business. Managing it efficiently is essential for success. It is often a lack of cash flow rather than a lack of sales that prevents companies from developing beyond their initial stages. Factoring agreements are one way that businesses with established sales can, for a price, guarantee smooth cash flow. Since factoring is a practice based on lending against accounts receivable, it is not a realistic source of capital for start-ups.
There are two primary financing agreements entered into by factor companies, recourse and nonrecourse financing. Recourse financing is an agreement under which the borrower maintains the responsibility for any bad debt or uncollectible invoices that it has issued. Nonrecourse financing is the term used when the factor company bears the risk of collecting from its client's clients. It takes on the responsibility for collecting and covers uncollectible invoices.
HOW FACTORING WORKS
The factoring process varies from agreement to agreement but the basics are similar in most situations. A business that is working with a factoring company, upon invoicing its clients, will send a copy of each invoice issued to the factoring company. On receipt of the invoices, the factoring company immediately provides its client with 80 to 85 percent of the value of the invoices received.
Once the outstanding invoices are paid by the busi-ness's customers to the factoring company it pays the business the remaining 20 percent of the value of those invoices less prearranged charges. Factoring charges include a fee and interest on the 80 to 85 percent paid in advance of collections.
In some respects, the factoring process is roughly comparable to credit card arrangements. Just as MasterCard buys a retailer's receivables and pays the store as soon as a sale is made, factoring companies do much the same thing on the wholesale level. For example, assume a toaster manufacturer ships a $150,000 order to one of its customers. Rather than waiting for the customer to pay, the manufacturer can sell the receivables to a factor, receiving up to 85 percent of the $150,000 total as soon as the goods leave the shipping dock and an invoice is sent. This speeds the collection process. The balance is paid, less factoring charges, when the factor collects from the toaster manufacturer's customer.
Small business owners should be aware that factoring is different in several fundamental respects from bank financing. For one thing, it is much more expensive. Factoring charges can cost between 2 percent and 10 percent of sales. Arrangements for fees vary widely, depending on the credit quality of the borrower's customer account balances and the range of services that are purchased from the factor. In addition, small business owners should recognize that utilizing a factor company is an all-or-nothing proposition. Factors generally demand 100 percent of a client's receivables. They will not limit their efforts to those receivables considered marginal or high risk.
GROWTH OF FACTORING
Factor companies are an increasingly mainstream choice for small business owners seeking capital. According to the World Bank, in its report entitled Financing Small-and Medium-Size Enterprises with Factoring, the volume of business handled by factors in the United States increased 15.2 percent between 1998 and 2003. Indeed, even though factoring carries some risks for small enterprises, it is regarded as a viable short-term cash management tool.
Factoring companies usually include a range of accounts receivable services as a part of their overall service. These services include such things as bookkeeping, collections, and credit verification. By reducing the in-house cost of managing these tasks it is more likely that a business will be able to justify the cost of working with a factoring company.
Although the cost of working with a factoring company is high, it may still be more cost effective than offering customers a 6 percent early payment discount in order to encourage the early payment of invoices. A factor will provide a business with cash almost immediately upon shipping a product whereas early payment discounts will usually only bring in payments marginally sooner than would be the case without the discount. Working with a factor is far more likely to offer substantial cash flow benefits than simply speeding up the collection period. The growth of factoring suggests that many companies are finding it a profitable way in which to help manage cash flow.
SELECTING A FACTOR
Selecting a factor is much like selecting any other service provider. The objective is to find the best price for the services provided. Several considerations that should be weighed by the small business owner in making fee arrangements with a factor include:
- Recourse—Small business enterprises that elect to go with a recourse factor (in which they bear final responsibility for collecting monies owed) over nonrecourse factors (where the factor company bears that responsibility) will find that they may gain lower fees and more money from the factor in return for increasing their risk.
- Customer Base—The larger the number of customers a business has, the more cost advantages the factor can offer the business. Automation provides factors with significant economies of scale when a large number of customers are involved.
- Creditworthiness of Customers—Factor companies will assess the credit worthiness of a business's clients and use this as an important element in pricing the factoring services for that business. Factors will not purchase substandard customer balances.
- Size and Age of the Average Invoice—Smaller receivables that have been on the books for a while will result in less advantageous factoring arrangements for small business owners than will large, current receivables.
- Factor Preferences—Some factors tend to work with larger businesses, while others concentrate their efforts on smaller enterprises. Large factor companies tend to focus their attentions on companies that have at least $10 million in annual sales, while smaller factor companies—sometimes known as "re-factors"—may provide services to companies with annual sales as low as $300,000.
- Industry Knowledge—Most factors that reach agreements with small businesses will have a fairly solid understanding of the industry and competitive environment in which those businesses operate. Such factor companies can provide help to small businesses in determining who they should (and should not) extend credit to. In addition, factor companies can be helpful in settling upon credit limits for both new and existing customers.
- System Compatibility—Most businesses in today's environment have implemented automated processes to calculate and monitor accounts receivable and cash applications of cash received. Small business owners should make sure that their systems are compatible with those of the factor before agreeing to a factoring arrangement.
- Collections—As indicated above, this can be a tricky area for the small business owner. Handing over collection duties to a factor company is expensive, and over-aggressive collection efforts on their part can damage a small business's relations with legitimate clients. However, factor companies often have better luck in collecting money owed than do small business enterprises, which have more limited resources to dedicate to the collections process. Business owners should recognize, however, that the factor is only interested in business transactions in which their client is owed money. Factors will not be responsible for non-payment that is attributed to other issues, such as vendor disputes or defective merchandise.
A variety of institutions, including bank subsidiaries and finance companies, provide factoring services. These companies can be found via several different methodologies. The Commercial Finance Association offers a list of its members and their service offerings online at www.cfa.com. Many factoring businesses also advertise in local yellow pages under such headings as "factors," "financing commercial," "accounts receivable financing," or "billing service."
see also Accounts Receivable; Cash Flow; Discounted Cash Flow
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updated by Magee, ECDI