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Is factoring a good way for you to increase cash flow?

Much has been written about the difficulties smaller companies have in obtaining adequate funding for working capital to support their businesses.

Since colonial times factoring has been a major source of financing for companies of all sizes in a wide array of industries. Just about any type of company selling business to business can obtain funding through factoring.

The primary requirement is that they sell goods or provide services that are invoiced under normal trade terms, not consignment or contingent sales, and the invoices are issued to businesses, not individuals.

Factoring 101

Factoring is a form of accounts receivable financing, and (full disclosure) my company offers factoring as a service. Under a factoring relationship, a company sells its invoices to the factor, who advances 75 percent to 85 percent of the invoices, thereby gaining immediate availability of funds for its sales rather than having to wait for its customers to pay.

When the invoices are paid, the factor deducts the amount it advanced and the factoring fee, then remits the balance to the company. The company normally can choose which invoices it wishes to factor as well as when they do so, allowing them to get cash only as needed.

The most important benefits of factoring are immediate availability and speed. Since the main support to a factoring transaction is the credit worthiness of the company's customers, businesses that otherwise could not obtain financing — such as high-growth, highly-leveraged, negative net worth, losses — can do so through factoring.

Typically, even a newly-formed or relatively small companies can obtain funding within 5-10 days rather than be forced to wait during an extended review and committee approval process. Funds then become available to a company as soon as the invoice is verified as valid, thereby eliminating the need to wait for 45-90 days or more to receive payment.

Cash flow benefits

This increased cash inflow can be used to meet payroll, pay suppliers, purchase additional goods for sale or meet other operating needs. Importantly, the company has the benefit of the factor's analysis of the credit worthiness of its customers and assistance with collection.

Not only can a company receive cash as soon as the sales are made, but the amount it can receive is limited by their ability to sell rather than an arbitrary limit placed by a lender. In many cases because of factoring, the company can extend payment terms to its customers and also can take advantage of the same prompt payment discounts for its own payables that its customers take. Companies can focus their attention on growing their businesses rather than struggling to find cash to pay bills.

Some companies fear that their use of factoring will be considered a sign of weakness with their suppliers and/or customers. While that may have been true to some degree 10-20 years ago, suppliers are happy to sell knowing there is funding in place that will allow their bills to be paid. On the other side, most customers are reassured by knowing that the company with whom they are working has solid funding in place to fulfill its orders.

As compared to other forms of financing, factoring is generally more expensive than bank loans or asset based lending and much less costly than equity. Factoring fees charged typically range from 1 percent to 3 percent per month of the face amount of the invoice(s) being factored and can be broken into daily, weekly or other increments.

The fee as related to any individual company is based on a number of considerations, including the quality of the company's customers, the average size of its invoices, the strength and viability of the company and its owners, and the level of risk perceived by the factor. Most importantly, factoring is a vital source of capital when other alternatives are not available, regardless of the reason, and often provides the company with more funds than do alternative sources.

Jim Lewis, Contributing Writer
Mar 6, 2015, 11:33am EST