Definition: A financing method in which a business owner sells accounts
receivable at a discount to a third-party funding source to raise
capital
One of the oldest forms of business financing, factoring is the
cash-management tool of choice for many companies. Factoring is
very common in certain industries, such as the clothing industry,
where long receivables are part of the business cycle.
In a typical factoring arrangement, the client (you) makes a
sale, delivers the product or service and generates an invoice. The
factor (the funding source) buys the right to collect on that
invoice by agreeing to pay you the invoice's face value less a
discount--typically 2 to 6 percent. The factor pays 75 percent to
80 percent of the face value immediately and forwards the remainder
(less the discount) when your customer pays.
Because factors extend credit not to their clients but to their
clients' customers, they are more concerned about the customers'
ability to pay than the client's financial status. That means a
company with creditworthy customers may be able to factor even if
it can't qualify for a loan.
Once used mostly by large corporations, factoring is becoming
more widespread. Still, plenty of misperceptions about factoring
remain.
Factoring is not a loan; it does not create a liability on the
balance sheet or encumber assets. It is the sale of an asset--in
this case, the invoice. And while factoring is considered one of
the most expensive forms of financing, that's not always true. Yes,
when you compare the discount rate factors charge against the
interest rate banks charge, factoring costs more. But if you can't
qualify for a loan, it doesn't matter what the interest rate is.
Factors also provide services banks do not: They typically take
over a significant portion of the accounting work for their
clients, help with credit checks, and generate financial reports to
let you know where you stand.
The idea that factoring is a last-ditch effort by companies
about to go under is another misperception. Walt Plant, regional
manager with Altres Financial, a national factoring firm based in
Salt Lake City, says the opposite is true: "Most of the businesses
we deal with are very much in an upward cycle, going through
extremely rapid growth." Plant says you may be a candidate for
factoring if your company regularly generates commercial invoices
and you could benefit from reducing the time receivables are
outstanding. Factoring may provide the cash you need to fund growth
or to take advantage of early-payment discounts suppliers
offer.
Factoring is a short-term solution; most companies factor for
two years or less. Plant says the factor's role is to help clients
make the transition to traditional financing. Factors are listed in
the telephone directory and often advertise in industry trade
publications. Your banker may be able to refer you to a factor.
Shop around for someone who understands your industry, can
customize a service package for you, and has the financial
resources you need.