Three times in the past week someone has mentioned "factoring" to me as a way to help my temporarily cash-strapped business. Can you explain this process to me in plain English?
Ignorant in Iowa
In plain English, factoring is selling the value of what your customers owe you before they owe it. Factoring is the sale of accounts receivable, as opposed to borrowing against them as you would do in accounts receivable financing. By selling your invoices, you generate cash immediately instead of having to wait for your customers to pay you.
The good news is that the factor company that purchases your receivables takes title to the invoices and collects them when they are due. That company also assumes responsibility for all of the costs, as well as the hard work and hassle that comes with customer debt collection. Commercial finance companies, some banks, and a variety of other types of financial companies will often factor receivables. For businesses with relatively small accounts (e.g., less than $10,000), it may require some effort to locate a factor company willing to purchase low amount receivables. Your local telephone book may list factoring "brokers" that can assist you in locating suitable factor companies.
The bad news is that factoring is not cheap; the cash price of the accounts receivable is rather heavily discounted by the factor company. Your final cost will nearly always exceed the amount you might have paid as an interest rate on a short-term commercial loan for an equal amount. Moreover, because factoring requires accounts receivable, it is usually limited to existing businesses. Factoring is generally used by rapidly growing businesses ($125,000 to $10,000,000 in annual sales) that face temporary cash flow problems. Except in certain industries, such as the garment industry, factoring is not used on a long-term basis.
The advantages to factoring include:
- Quick cash — You can receive quick payment in cash after the time of shipment, delivery and invoicing a customer. This immediate payment for invoices nearly eliminates the sale-to-collection business cycle and allows businesses caught in a cash crunch to obtain fast relief. If a relationship with a factor already exists, turnaround on the sale of receivables should take only about 24 hours. When making a first-time purchase of invoices from a business, factors typically take one to two weeks to check the credit ratings of the customers and communicate a discount price.
- No debt — Factoring is a sale of assets (invoices), not a loan. For businesses that either cannot qualify for traditional debt financing or that simply do not want to incur more debt, factoring is good alternative means of financing.
- Elimination of collections — Most factoring is called "non-recourse," meaning that the factor company purchases all rights in the invoices and the seller has no responsibilities for collection. The factor's anticipated cost and time in making collections is computed into the discounted purchase price of the receivables. In some states, however, "recourse" factoring is also permitted. In recourse factoring, you are secondarily liable for any invoices not collected. The factor company undertakes debt collection, but you remain ultimately responsible to repay any portion of the cash price attributable to an account that went uncollected.
The disadvantages to factoring are:
- Cost — Traditional loans will typically be less expensive than the costs of factoring. The upfront cash price for accounts receivable is typically 70 percent to 90 percent of face value, depending upon the credit history of the customers and the nature of your business. The initial price is treated as a cash advance and you typically receive an additional portion of the face value when (and if) the accounts are collected. Your final price is usually between 90 percent to 95 percent of the original invoice amount. The longer the invoice period, the higher the rate. Most factors will not take invoices with longer than 90-day payment periods. In addition, the credit history of the customers can affect your final costs. While a 5 percent cost may not seem particularly expensive, remember that most invoice cycles are only 30 to 90 days. Paying a 5 percent discount, once a month, for factoring an average 30-day invoice amount of $10,000 is the equivalent of a 60 percent annual percentage rate.
- Possible harm to customer relations — Collection actions taken by the factor company may endanger an ongoing business relationship with one of your customers. In a small business, there may be circumstances in which you would compromise a debt, extend payment deadlines to a preferred customer, or employ a more lenient collection approach for a specific customer. A factor company has little interest in preserving your future relationship with the debtor and some companies may be overzealous in collecting receivables.
Factoring agreements can be quite flexible, and you should always try to negotiate for the best terms possible. Renegotiating for a lower discount percentage is common in ongoing factor relationships; however, the most negotiable charges are often not the initial discount percentage, but other additional charges (such as a fee for expedited wiring of your cash price or an initial user fee) assessed by most factor companies.
As an alternative means of financing a short-term gap in cash flows, factoring can be an effective—albeit expensive—solution.