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.