Like nearly every business, yours needs working capital. The problem is, your cash receipts from customers tend to come in more slowly than your expenses need to be paid.
If you sell goods or services, you probably invoice your customers on 30-day terms. Customers, however, often don’t pay for 45 to 60 days. In the meantime, your creditors won’t wait to be paid. You need cash to cover the gap. This funding gap may prevent your company from growing as fast as it could.
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Many companies look to bank loans for funding. Unfortunately, banks can be particular about whom they lend money. Banks tend to have stringent requirements.
So many business owners use credit cards, home equity loans, equipment leases, personal loans from relatives and “stretching” their vendors to cover that gap.
But other types of financing are available. Many businesses that sell to other businesses have found that a financing tool called “factoring” provides an alternative to bank loans and other sources of working capital. Factoring provides your business with cash based on your receivables. You sell your invoices to the factoring company and receive much of the value immediately.
Factoring fits in well with the needs of a company on the rise, three to five years old, that has a lot of receivables. Service businesses, from temporary staffing to trucking, are particularly well-suited to using factoring as a financial tool.
Though long a traditional financing method in Europe, factoring has not been well-known in the United States. However, it is becoming much more widely used here, showing growth from $65 billion per year to $112 billion between 1995 and 2005.
What is factoring? Imagine that your customers paid their invoices right away. What would that do for your working capital? Factoring gives you the same advantage. You sell your invoices to a factor, which immediately gives you 70 percent to 90 percent of the value of the invoices. After the factor receives payment, you receive the remainder of the invoice, less a fee. This fee, or “discount,” is usually a small percentage of the original invoice amount. This is the factor’s profit.
How does it work? Technically, factoring is not a loan; it is a purchase of the invoice. In practical terms, however, it works like a loan, with each invoice being used as collateral.
You apply to a factoring company in ways similar to applying for a bank loan. Since the factor will receive payment from your customers the factor will be looking at the creditworthiness of your customers.
Approval tends to be quicker than it is for a bank loan, often in two weeks. After you sign the agreement with the factor, you will be able to sell your invoices. Then the factor pays you, so the cash can be in your bank account the day after the factor receives the invoice.
When you factor an invoice, your customer will be paying the factoring company, not you. This can be confusing to a customer. Part of the factor’s job is to explain the process to customers. However, you or your company’s staff should also personally tell your customers what to expect.
Once you establish a factoring relationship with a finance company, you can sell some or all of your invoices, depending on your need for cash.
Besides the direct financial transactions, a factor also can provide a whole range of “back office” services. If you don’t have a controller, a credit manager and sophisticated accounting software, you may find it convenient to leave many of those functions to the factor. Many factoring companies can provide a variety of services relating to receivables: checking customers’ credit, creating invoices, collecting on the invoice, even making collection calls.
What happens if the customer doesn’t pay the invoice? Your factoring agreement will likely require you to pay the factor for any invoice that goes unpaid for 90 days. Depending on your agreement, you may also be able to replace a bad invoice with another of the same value. Finding a factor is not overly difficult. Most banks don’t offer this service, but your banker or business colleagues also may have recommendations.
Whether you get a referral or not, carefully evaluate the factoring company. Important qualifications include:
Experience: Does the factor have experience in processing invoice advances?
Capacity: Does the factoring company fund its invoices itself? Or does it just broker the transactions to another source?
Technology: Is the factor able to receive invoices electronically and process them rapidly, for quick payment?
If you sell to other businesses, factoring may be a useful tool to help you take advantage of your sales to help your company grow. When you start to think that you could sell more if you had more working capital, that’s a good time to take advantage of factoring as a financing option.
Robert Fluharty is vice president of business development for Systran Financial Services of Textron Financial Corp., a provider of factoring and asset-based lending services to businesses in the Northeast.
