Why It’s Time to Bring Factoring Into Your Financing Equation

By Tom Klausen and Vincent Leusner

In your search for commercial financing in the midst of the ongoing credit crunch, here’s something to factor into your consideration: It may be time to look at factoring in a whole new light.

It’s unfortunate that, for whatever reason, factoring has gotten a bad rap. A lot of the myths about factoring simply aren’t true—for example, that factoring is too expensive to be considered a viable commercial financing option for the average small business. In truth, factoring can make the difference between success or failure for companies operating without adequate working capital—at a cost that’s probably a lot less than most business owners think.

How Factoring Works: With factoring, companies sell or borrow against their outstanding commercial accounts receivable. The cost is a fee called a discount—typically between 2-5% of the invoice or the amount borrowed. By factoring, companies immediately benefit from improved cash flow: Instead of waiting somewhere between 30 and 90 days or longer to receive payment, they will receive approximately 80 percent of the receivable in the form of an advance when the receivable is presented to the factor. 

In addition, the factor performs credit checks on customers and analyzes credit reports to uncover risks and help manage appropriate credit limits. Most factors will also provide a follow-up service to assist with keeping the debtors paying more promptly.

One thing to note is that factors need to be more insightful about the inner workings of their client’s business than traditional lenders are. Since they are lending against their client’s outstanding receivables, it’s their job to know all about the client’s customers, terms, backup and the billing process itself. Factors need to possess an in-depth understanding of their clients’ industries and the business nuances between their clients and the clients’ customers.

A Factoring Success Story: An industrial service business in Philadelphia recently entered into a factoring arrangement with a well-established factor because it was in need of short-term working capital assistance and decided on a factoring arrangement instead of a traditional line of credit

Since the business’ customers are of high credit quality, factoring was a logical credit facility for them to turn to. The business has been factoring invoices for several months now and is extremely pleased with the arrangement. The owner especially likes the fact that he can use the factoring company’s online system to determine how much money he can borrow through factoring at any time, 24/7. This is a big help when it comes to daily cash flow and working capital planning.

Factors for Success: Here are a few areas you should concentrate on in order to increase your chances for factoring success:

• Financial statements, management reports and forecasts: It is important to generate accurate and timely financial statements, as well as for the owner to know exactly where the business is financially at all times—and where it’s headed. By accurately tracking factoring fees, the business is better able to build in and earn back those fees. Value will be gained via an increase in gross sales, discounts for paying vendors early and overhead reduction. Factoring will look expensive unless it is properly measured against the value it brings.

• The factoring contract: Be sure that you understand all details in any contract you sign with a factor, as well as the fees you will be charged. Beware of factors who issue a term sheet without doing proper due diligence. What may appear to be a low factoring rate at the outset could end up being very expensive when things like lockbox, minimum usage, credit checking, and wire transfer fees are included.

• Monitoring of factoring facility and working capital: Make sure that a senior financial person on your staff has sufficient time to monitor usage of the factoring facility and working capital-oriented items. By borrowing only what you absolutely need, you will be able to minimize your factoring expense. It’s also important to monitor the aging reports and become involved if any trade or payment disputes arise.

• Maximum efficiency: Increasing efficiencies in your backroom operation can have significant positive implications on your bottom line. By understanding all the services that your factor performs, you will be able to better utilize your staff and your own time. Understanding the reports and implementing controls and procedures will minimize errors and increase efficiency.

• Open communication: It’s important to have a clear channel of communication with your factor. You might be surprised at the flexibility your factor (and others) will provide when you are open and honest with them. It’s also important that you communicate directly with the factor if you are aware of any issues or problems with your invoicing or customers. A good factor can deal with most issues if aware of them—but like most lenders, factors don’t like to be surprised.

Since a factor will become an integral part of your business team, it’s important to select your partner carefully. Professional experience and adequate capitalization are especially crucial. Don’t be fooled by Internet claims of very low rates and a “24-hour application process.” Good factors are as choosy about their clients as you should be about your financial partner. When everyone performs their proper due diligence, you are more likely to build a foundation for a positive relationship for many years to come.

Read other articles and learn more about Tom Klausen.

Vincent Leusner of B2B CFO® assists companies that are facing complex financial and strategic issues and are in need of senior financial talent.  Every company, regardless of size, needs a Chief Financial Officer (CFO). The best CFOs keep an eye on the whole company, not just the bottom line. As a B2B CFO^® partner, his job is supporting a client's entire organization, including sales, marketing, production, operations, staffing and other relationships, both internal and external. Reach him at vleusner@b2bcfo.com.

[Contact the author for permission to republish or reuse this article.]