Factoring

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 thecash-management tool of choice for many companies. Factoring isvery 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 asale, delivers the product or service and generates an invoice. Thefactor (the funding source) buys the right to collect on thatinvoice by agreeing to pay you the invoice’s face value less adiscount–typically 2 to 6 percent. The factor pays 75 percent to80 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 theirclients’ customers, they are more concerned about the customers’ability to pay than the client’s financial status. That means acompany with creditworthy customers may be able to factor even ifit can’t qualify for a loan.

Once used mostly by large corporations, factoring is becomingmore widespread. Still, plenty of misperceptions about factoringremain.

Factoring is not a loan; it does not create a liability on thebalance sheet or encumber assets. It is the sale of an asset–inthis case, the invoice. And while factoring is considered one ofthe most expensive forms of financing, that’s not always true. Yes,when you compare the discount rate factors charge against theinterest rate banks charge, factoring costs more. But if you can’tqualify for a loan, it doesn’t matter what the interest rate is.Factors also provide services banks do not: They typically takeover a significant portion of the accounting work for theirclients, help with credit checks, and generate financial reports tolet you know where you stand.

The idea that factoring is a last-ditch effort by companiesabout to go under is another misperception. Walt Plant, regionalmanager with Altres Financial, a national factoring firm based inSalt Lake City, says the opposite is true: “Most of the businesseswe deal with are very much in an upward cycle, going throughextremely rapid growth.” Plant says you may be a candidate forfactoring if your company regularly generates commercial invoicesand you could benefit from reducing the time receivables areoutstanding. Factoring may provide the cash you need to fund growthor to take advantage of early-payment discounts suppliersoffer.

Factoring is a short-term solution; most companies factor fortwo years or less. Plant says the factor’s role is to help clientsmake the transition to traditional financing. Factors are listed inthe telephone directory and often advertise in industry tradepublications. Your banker may be able to refer you to a factor.Shop around for someone who understands your industry, cancustomize a service package for you, and has the financialresources you need.

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