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How to use factoring to increase cash flow

The notion of factoring has been around for centuries. Although the concept is relatively simple, many entrepreneurs and business owners working in complex fields have never even heard of it, which could be to their detriment.

At its most basic, factoring is simply selling your accounts receivable to a third-party in order to gain immediate access to the owed working capital. The third-party, called a factor, charges a percentage of the transaction in return for taking on the risk that the customer will eventually pay. The percentages vary depending on a number of variables, but usually run from less than 1 percent to 3 percent.

Factoring has traditionally been associated with the garment industry, where it is still common, and at times has been linked with companies in financial trouble. Jon Lucas, president of CIT Trade Finance in New York, said the stigma associated with factoring is an anachronism.

“The factoring product with the ability to get advances is a great alternative to finance the working capital of a business,” Lucas said. “You’re getting a lot of benefits that a bank loan doesn’t provide.”

Experts in the field said factors can be useful for new businesses that don’t have the benefit of robust cash flows or extensive credit histories. Factors can help such businesses bridge the gaps caused by the customary 30- to 45-day waiting period associated with invoices. Unlike banks, which are obviously concerned with the financial condition and credit-worthiness of a company, factors are concerned only with the credit histories of the company’s customers and their ability to pay.

Gary Honig, president of Creative Capital Associates, a Washington, D.C.-based factoring firm, said this can be useful, especially for businesses struggling in a down economy.

“Maybe they’ve racked up all kinds of credit card debt and they don’t have much in collateral, but they got this great new contract with some big company,” Honig said. “So, they can leverage those invoices to pay their people.”

But not every company that uses factoring does so to improve cash flow. Lucas said many of CIT’s clients don’t take advances, instead they factor because it allows them to avoid having to employ an in-house accounts receivable department. Instead, CIT receives payments from the company’s customers, applies them appropriately and reports all the data electronically to the company.

Some factors are employed by companies because factors can often do a better job of evaluating the credit risk associated with the company’s customers. Other companies use factors to offset risk during good times.

“If business is booming and you want to go over and above your credit lines, you can sell us that exposure,” Lucas said. “You can stay within your line but sell us what’s over the credit line as a risk mitigation strategy.”

There are many types of factoring, but two common categories are recourse and nonrecourse factoring. In recourse factoring, the risk for a nonpaying customer remains with the factor’s client. Nonrecourse factoring means the factor takes on the entire risk associated with nonpayment. If a customer doesn’t pay, the factor does.

“The one thing the factor does not assume is any risk other than the financial inability to pay,” said Paul Hahn, an attorney and factoring expert in New York. “So, if there’s a dispute of any kind, the factor has the right to charge the receivables back. I’ve been in the business 30 years and I’ve never heard of a factor assuming any dispute risk.”

Honig said one common complaint about factoring is its expense. He said most people look at the percentages, multiply them by 12 months and immediately assume that factoring companies are “just raking it in.”

Not so, he said. Factoring requires much more of a hands-on approach than a traditional bank loan, which is a benefit, but one that isn’t free.

“All of us in the factoring community, we have staff that is monitoring the account debtors’ credit, notifying customers, verifying invoices, collecting on invoices,” Honig said. “We have a heavy transaction load and that costs money. On top of that, all factoring companies borrow money, so what you’re really doing as the client is leveraging my ability to borrow money.”

Honig advised anyone interested in employing a factoring company to ask questions to become familiar with their operating procedures. Factoring companies often operate differently, he said.

Honig suggested finding out how the factors do their notifications and verifications. Notification takes place when a factor informs a client’s customers that the proceeds of any invoice will be assigned to a finance company. Verification is when a factor verifies the work related to the invoice has been completed.

Honig also said to consider factoring a tool to be used in the right situation. For example, a business operating on a slim margin might not employ factoring because the commissions could eat up the margin. On the other hand, a smaller or newer business with a cash-flow shortage might benefit because it would allow them to avoid the “robbing Peter-to-pay-Paul” conundrum.

One other thing to consider is that some smaller factors are specialized to certain industries.

“You might have a trucking or health care or construction factor,” Honig said. “Each specializes, so it’s important to engage with a factor who works within your industry.”

Factoring Tips:

  1. Know your financial situation and whether a factor would suit your business.

  2. Research, research, research. Call multiple factors and find out their operating procedures. They tend to vary from factor to factor. Don’t forget that some factors are industry specific.

  3. Remember, factors can benefit your business in more ways than just cash flow. They can be employed to outsource your accounts receivable department or as part of a risk-mitigation strategy.

Company: Jan 24, 2013