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Accounts Receivable Factoring Explained

What is “Accounts Receivables Factoring”? Factoring involves the purchase of the face value of your accounts receivables or invoices by a factoring company at a small discount in exchange for an immediate cash advance, usually in the form of a wire transfer. Factoring accounts receivables, or “accounts receivables financing” as it is also known, provides billions of dollars in operational cash flow for companies each year. Once only used by a small group of industries, accounts receivable factoring is increasingly used by entrepreneurial businesses who may have trouble securing loans from a bank. As banks pull back, accounts receivable factoring is filling the financial void.

Why is “Accounts Receivables Factoring” important? Essentially, the use of a commercial finance company to factor your invoices is an off balance sheet transaction. This means that when you get beyond the need for financing you have no net term liability to be paid off. Each purchase of an invoice by the factoring company, when paid by the customer, is a completed finance transaction.

How is it done? The practice of factoring has been around for thousands of years. Whenever someone is owed money, there has always been someone else willing to take a cut of future income in exchange for providing “instant relief” to the owed party.  The most common example of a modern receivable finance vehicle is the credit card. A merchant gets paid by the host bank before its customer gets around to paying the bill, and the bank takes a percentage of the customer’s payment.  The factor works in similar fashion, providing capital either by purchasing the asset value of a receivable (non-recourse) or by making a loan with the invoice as collateral (full-recourse). Some factors are private individuals with huge cash bankrolls, while others are public companies accountable to shareholders. When the factor purchases the value of the receivable, it takes the credit risk that the invoice will be paid, while the client retains the performance warranty on the work done for the customer. The factor usually performs a credit check on the customer before deciding to purchase the receivable. When a factor makes a loan against an invoice – which typically occurs when customer credit is not favorable – its client continues to assume the credit risk, and will be liable for non-payment.

How common is accounts receivable factoring? Since the factor often helps provide financial discipline for its clients, it isn’t uncommon for a bank to recommend a factor to a client seeking a loan without the adequate credit record. Banks see factoring as an interim solution to inadequate credit. A few institutional banks offer accounts receivable financing directly. “Sometimes a company can’t pursue conventional financing,” says Michelle Douglas of Southern Financial Bank. “Factoring allows companies the opportunity to secure short-term working capital to get them in a better position to secure a banking relationship.”  An honest – and smart — factor wants its client to eventually graduate to conventional banking relationships. A company which cannot establish an exemplary credit history can eventually become a bad risk for any financial partner. The factor’s ideal partnership is with a new or reorganized company with a bright future – one which probably won’t include depending on a factor for more than limited time.

How does the perception of factoring affect a business that uses factoring? Until recently the use of a factor was thought to indicate that a company had fallen to the bottom of the financial pecking order. The perception of the factor as the last line in a shaky financial defense has persisted largely because of the unregulated status of the factoring industry. “The general misconception is that the only time to use a factor is when your company is going out of business” says Gary Honig, President of Creative Capital Associates. “Exactly opposite is the truth: Factors want to work with companies in a growth mode. They are as unlikely as any financial institution to invest in a failing company.”

What has changed? The factoring industry is growing and has shaken out shady players through a combination of competition and the establishment of sound operating procedures. Factors watch each other closely and now provide assistance to one another much like banks do. Some factors specialize narrowly, dealing with just medical or construction receivables, for example. These factoring companies comprehensively learn their clients’ business and industry. And while they often deal with companies unable to make a deal with conventional banks, the typical factoring company doesn’t take on all comers. Far from it. Since it will operate as a de facto partner or investor by assuming the risk of a company’s receivables, it’s in the interest of the factoring company to take on clients who are growing, solvent, and ambitious. “It’s critical to work with a factoring company who understands you and your business plan,” says Gary Honig. “Most factors aren’t willing to take on just anybody, and you should be wary of any factor who gives the impression that they’re willing to do business with everybody. Normally, you shouldn’t use a factor beyond the growth spurt that initiated the need for one. You should use a factor to get to better terms.”

And terms, of course, vary greatly. The factor generally discounts the full face value of an invoice by a certain percentage. Rates are generally determined by risk and volume. High risk is more expensive; low risk less expensive. Low volume, measured in dollars per month financed, is more expensive; high volume less expensive. If a client can guarantee it will need factoring for a specific amount of either time or money, the rate is lowered. Some factors provide annual APR rates which are tied to the amount of financing outstanding, while others simply discount invoiced amounts between two to six percent.

It’s rare to find two factoring companies which operate entirely alike, partly because of the absence of regulation. Each factor has its own method to sort out credit issues, notify a client’s customers, and verify that invoices are real and collectable. Some factors will also operate as a collection agency.

So what’s the good news? Even skeptics admit that there factoring offers some unique benefits. First and foremost is retention of equity, which remains unchanged on the company balance sheet when a factoring arrangement is established. A conventional bank loan or credit line shows as an on-going liability on company books. Also, entering into a relationship with a factor – and getting capital – takes only a few days. For companies wrestling with a cash flow crunch, the immediacy of funding available through factoring is often the deal-maker. “We’ve been operational for over twelve years, and recently we got into a pinch due to some new and large accounts,” notes Doug Beaver, owner of Gaithersburg-based Amguard Security Services. “Rather than going through a total re-application of our bank line, we used a factor for short-term working money until the new accounts became self-payable. Having never used a factor before, I was surprised how quick and painless the process was.” But no aspect of the factoring business is as highly regarded as its flexibility. Compared with the usually rigid practices of both your neighborhood and downtown bank, a factor can be just the fresh opportunity a business needs to blossom. “Our business grew ten-fold in less than two years,” says Anthony Wright of Virginia-based P&W Surplus Office Movers, “And factoring allowed us to sustain that kind of growth. It gave us flexibility.”