Filed under Finance
by Ignorant in Iowa | October 28, 2011
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:
The disadvantages to factoring are:
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.