Factoring

Business owners can, with the blessing of their bank, use the factor to supply the cash flow to cover the cash needs that exceed their bank line. When appropriate, the banks have been happy to work together with local, reputable and established independent (non-bank) factoring firms to satisfy the customer’s needs.

Factors are commercial finance organizations which fund/purchase one or more specific invoices for work performed for a business customer or for the local, state or federal government.

Factors fund quality invoices, not collection problems and provide from $1,000 to $500,000 and higher. Although the factoring industry has been helping the cash flow of various clients/industries for more than 50 years, it has only been active in Hampton Roads for the past seven years. The large factoring firms are usually subsidiaries of large banks and the smaller factors are usually independent (non-bank).

Factoring functions like a line of credit, but is different from a line of credit/loan secured by accounts receivable in that it is actually a sale of specific accounts receivable/invoices to the factoring firm.

The customer may or may not see a significant day to day difference between drawing on a bank line of credit and factoring an invoice(s), depending on the factoring firm’s funding guidelines.

The factor bases its decision primarily on the financial strength and payment history of your firm’s customer. Thus, factors can often help recent start-ups and undercapitalized companies.

Fast factoring

The start-up firm that cannot obtain conventional financing from a bank or government loan program and whose payment and/or cash flow cycle is outgrowing its equity, can use factoring to bridge the gap and increase sales.

For example, a small firm needs cash to fill orders, will not receive a customer’s payment for up to 30 days, and has exhausted its line of credit with a bank. Management calls a factoring organization that analyzes the potential receivables and agrees to buy them.

• The bank must approve if they have a first lien.
• When the firm submits an approved invoice the factor enters the amount in their record keeping system, verifies the invoice with the firm’s customer, stamps the invoices payable to the factor, and sends them off for payment. Most factors immediately pay up to 80 percent of the value of the invoice.
• When the invoice payment is received, the factor deducts the initial payment and his/her fee, paying the customer the remainder.
• This analysis can be done much quicker than a bank or government loan review.
  It happens fast, said one caller, with approval and closing of the first funding usually transpiring within four to seven days of application. Future invoices can be funded in as little as 24 hours.

Application Process

The application process is quick. Your company fills out the application and submits recent corporate financial statements, last year’s tax return, an accounts receivable aging and an accounts payable aging – the standard financial reports which a business owner should have readily available.

The factoring firm will ask you about whether you have presently financed your business via bank loans, leases or otherwise. The factoring firm will conduct a lien search (UCC-1 search) to learn if any lender has taken a first lien position in your company’s accounts receivable as collateral.

If a lender/bank has a first lien on receivables, the lender must consent before the factor can fund. If there is enough collateral and a good relationship, the banks are usually agreeable to allowing a factor to help. There is no need to switch banks and lose a good relationship.

The second question a factoring firm will ask is about your customer base. As discussed earlier, the factor focuses primarily on the credit worthiness of your customer(s). The factor will be very interested in any history, positive or negative you can provide about your customer.

A local factoring firm should be able to provide you with a wealth of knowledge regarding local companies. Some factors offer credit advice as part of their standard service. All factors have access to credit databases.

Paperwork

Upon being approved by the factor, the business will have to sign paperwork very similar to that a bank requires. The paperwork will reference “purchase of sale” whereas the bank paperwork references “lend or loan”. Factors, like banks, usually require personal guarantees. As with any paperwork, all agreements should be read carefully and all terms and conditions completely understood.

Funding and customer payment

The factor helps your cash flow by immediately funding a 60-80 percent advance on each invoice. If invoices are submitted to the factor via fax by 10 a.m., the factor will usually verify the invoices and deposit the funds by 1 p.m. the same day directly into your bank account. Once your customer pays, the factor takes out the advance and a discount (their fee), and they deposit the difference (the settlement) into your account the next day.
Many independent factoring firms allow their customers the flexibility and convenience of receiving their customer’s checks, but the large factors require your customer to pay them directly or to send the check to a special post office box (a lockbox) which the factor controls, potentially causing you problems and negative publicity.

Cost of factoring

The flexibility of factoring may come at a premium. Factors rates are higher than banks; however, factors have only your invoices as collateral. The important point is that a factor’s funds can be used as growth capital. Your sales growth should create a much higher gross profit for your business, even after paying the factor. You build equity and become a better bank customer. Factors take a percentage of each invoice you submit to them as their fee, which they call a discount. Discounts range from 1.25 percent to 5 percent for every 15 days an invoice is funded. Some factoring firms charge a fee over prime plus a servicing fee, which makes the true discount difficult to determine.
The right rate for the right industry
A factoring company surveyed its clients with the question: “If every customer paid at delivery, what sort of cash discount would your company be willing to offer?” The results were anywhere from 5 percent to 15 percent with a median average of 9.6 percent. Inc. Magazine, May 1990 reports that the average fee charged by factoring companies point out that savings or fees is even greater as the company’s sales volume increases and its receivables prove to be bankable. An increase in sales, reduced overhead, increased production and reduced bad debt all lead to higher profitability. If used at the right rate for the right industry, factoring can be more beneficial than most other forms of financing.

Factoring strategically

Factoring is an appropriate financing mechanism for a number of small business situations assuming two conditions are met:

1. Conventional bank or government loan financing is either exhausted or unavailable
2. The firms profit margins and other financial goals can handle the expense of the factors discount on a specific job or contract or a series of jobs or contracts. For example:
   Some factors deduct 10-20 percent from the amount of the invoices your company funds through them and permanently holds your money in a restricted savings account in their bank. They label it a “reserve” or a “cash collateral account.” The amount held in reserve hurts your cash flow and increases your costs. Factors usually have recourse, meaning that if your invoices do not pay in the time period agreed to in the paperwork (i.e., 50 to 90 days from date of invoice), the factor can request that your company reimburse them for the invoice, often immediately. You need to have a clear understanding about how much flexibility the factor is willing to grant if the timing is not good when reimbursement is requested.

Factoring summed up

Factoring can be an excellent tool for a business owner to use to eliminate tight cash flow. As with any service you buy, it comes at a cost. As long as you can make money with the factor’s money, you should consider it a valuable second resource and explore its best uses.