Basics Of Factoring

Editor's Notes

• #2: Thank you for listening to this presentation about the basics of factoring. Factoring is a form of financing where a business’s unpaid invoices are used as collateral for cash advances. Factoring is also known as accounts receivable financing or invoice specific asset based lending. Over the next couple of minutes, we will explain how this form of financing provides more than just cash flow to a business. We will discuss the basic mechanics of how the money flows, differences between a traditional loan and factoring, what types of businesses benefit from factoring and what to look for in a factoring company.
• #3: Thank you for listening to this presentation about the basics of factoring. Factoring is a form of financing where a business’s unpaid invoices are used as collateral for cash advances. Factoring is also known as accounts receivable financing or invoice specific asset based lending. Over the next couple of minutes, we will explain how this form of financing provides more than just cash flow to a business. We will discuss the basic mechanics of how the money flows, differences between a traditional loan and factoring, what types of businesses benefit from factoring and what to look for in a factoring company.
• #4: Factoring has been around a long time, dating back to the days of Hammurabi. king of Mesopotamia and "cradle of civilization." Factoring endured civilizations, including the Romans who were the first to sell actual promissory notes at a discount. In colonial times, merchant bankers in London and other parts of Europe advanced funds to the colonists for their raw materials This enabled the colonists to continue to harvest their new land, free from the burden of waiting to be paid by their European customers.
• #5: Even if you have not heard the term, you are familiar with the practice of factoring. If you use a credit card, the merchant that accepts your card for payment, is willing to give up a percentage (usually between 1.75% and 3.5%) of the amount due, in order to receive immediate payment. You, as purchaser of the product or service, pays the credit card company the full amount instead of paying the merchant, and the finance company pays the merchant a discounted amount. In the small business world, companies usually sell their products/services and provide payment terms to their clients (usually 30 days). So, these small businesses are not just providers of goods/services, they are providers of free financing to their customers. Of course, most small businesses need to meet payroll, pay their mortgage or rent, buy more inventory, etc., before their customers pay for sales. This is where a a factor can step in.
• #6: At the transactional level, the small business simply submits an invoice to the factoring company after the good or service has been provided. The factor advances a percentage of that invoice to the business (in this example, 85%) for immediate use. The business’s customer pays the factor 30 days or so later. The factor then rebates the remaining amount of the invoice to the business minus their factoring fee. This is a basic example – most factors deal with multiple invoices everyday from their clients and can structure more complex vehicles to meet clients’ needs.
• #7: Let’s take a look at the difference between a traditional loan from a bank vs. factoring How does a bank underwrite a prospective borrower? Many of us have heard of the 5 Cs of underwriting in one form or another. An underwriter looks at the collateral backing the loan in case it needs to be liquidated for repayment. They also look at the capacity the borrower has to make the loan payment as well as all other payments in the business. The bank looks at credit history or how well the company or owner has paid other obligations. The bank may look at character issues such as criminal activity or lawsuits involving the borrower. And the bank will look at current economic conditions to determine whether the business is viable now and in the future. Think about how a bank services a loan. They do a lot of work on the front side in order to determine total credit quality: character, cash flow (including financial ratios), credit, collateral, etc. Once it is funded, very little servicing. When it is a problem, they spend labor on how to get repayment or liquidate. Factoring spends labor from day one. Each invoice purchased and advanced against is in a way, it’s own transaction that is verified and collected upon.
• #8: A factor looks mostly at the credit of the business’s customers, called debtors. Do the debtors have the ability to pay and willingness to pay for the good or service. The factor wants to see the business have good billing procedures so the factor know invoices will be paid as submitted. And the factor wants to know the business can provide the good or service without disputes. While a factor certainly wants to work with financially strong clients, it is not essential for the business to have a strong balance sheet and generally a factor is not concerned with particular financial ratios.
• #9: Of course factoring is more than just providing money to a business. A factor assists a business by professionally managing the accounts receivable process. A factor will be the business’s credit department and help determine which customers the business should be working with and how much credit to extend that customer. The factor will monitor the customer over time to make sure the credit limits are appropriate in a changing environment. A factor helps speed collections by talking with a business’s customers. Factors are not collectors, but there to facilitate an often undone facet of a small business (many owners don’t like to collect on invoices) Speeding collections improves a factors’ yield and most times lowers the fees the business pays to the factor. A factor will process payments and make sure the payment is going to the correct invoice. In some situations, a factor can process accounts payable for the business as well.
• #10: So, what businesses benefit from factoring? Just about any business that has business to business receivables can benefit from a factors’ services. Many start up businesses have a hard time getting traditional financing and can not always afford a full back office to assist with the billing and collection process. Businesses that are growing quickly need to access capital relative to their sales. Factoring lines grow as fast as a businesses sales do. In today’s environment, many businesses do not qualify for bank loans because of recent losses or erosion to the businesses equity. Factoring provides the necessary capital as well as added services.