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Factoring: 5 Things You Need to Know
Factors purchase invoices at a discount, which helps companies get paid more quickly. How to use factoring.
Posted 1/ 23 11 at 8:00 PM | 5 Things You Need to Know, Money, Taxes & Accounting, Business Products & Services, Financial Services
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Factoring used to have a stigma -- many considered it a last resort for businesses, somewhere between a liquidation fire sale and bankruptcy. But both the practice and the perception have changed in recent years, and those who still readily dismiss factoring probably don't fully understand it.Here's how factoring basically works: A bank or other financial institution purchases a company's outstanding accounts receivable or invoices at a discount, giving that company quick access to cash.
Think factoring could help ease some of your financial woes? Here are five things you need to know.
1
Know the definition of factoring.
Say you're an entrepreneur selling a line of clothing to a major department store (factoring is very popular in the retail industry). You deliver the clothes and send out an invoice. Your factor -- a bank or other financial institution -- then pays you a portion of your invoice, usually 75 to 80 percent, right away.
The factor collects the invoice from that major department store and forwards the rest of your money, that remaining 20 or 25 percent, minus its fee, which is generally around 2 to 6 percent. So if you have a $50,000 order you're waiting on, your factor will end up with $1,000 to $3,000 of that.
Factoring can help businesses better manage cash flow, especially with slow-paying clients. But there are other reasons, too. "Some companies don't want to have a credit department," says Louis J. Cappelli, chairman of Sterling National Bank in New York. "They're shipping merchandise all over the country. Effectively, they're outsourcing the credit and collection function."
In other words, you or your employees don't have to chase down the business or individual that owes you money. Your factor will.
The factor collects the invoice from that major department store and forwards the rest of your money, that remaining 20 or 25 percent, minus its fee, which is generally around 2 to 6 percent. So if you have a $50,000 order you're waiting on, your factor will end up with $1,000 to $3,000 of that.
Factoring can help businesses better manage cash flow, especially with slow-paying clients. But there are other reasons, too. "Some companies don't want to have a credit department," says Louis J. Cappelli, chairman of Sterling National Bank in New York. "They're shipping merchandise all over the country. Effectively, they're outsourcing the credit and collection function."
In other words, you or your employees don't have to chase down the business or individual that owes you money. Your factor will.
2
Factoring is now acceptible.
Factoring used to be looked down upon because hiring a factoring company was a little like hiring a tough guy. The client would probably pay up, but chances are, you wouldn't be working with that client again.
Today most, if not all, national banks act as factors for businesses -- it's considered part of "asset-based commercial lending." One reason is that banks, financial lenders and the factoring companies that exist now realized that while big companies may be late with payments, most of them are going to pay eventually. A small business may not be able to afford to wait around while Walmart or Macy's gets around to sending out that invoice, but a bank can -- and if it takes too long for that invoice to come around, they'll remind them.
And the accounts-receivable department at any major company you're working with isn't going to think any less of your company if it receives a letter or a call from a factor. They know all about factoring and accept that occasionally hearing from them is just part of doing business.
Today most, if not all, national banks act as factors for businesses -- it's considered part of "asset-based commercial lending." One reason is that banks, financial lenders and the factoring companies that exist now realized that while big companies may be late with payments, most of them are going to pay eventually. A small business may not be able to afford to wait around while Walmart or Macy's gets around to sending out that invoice, but a bank can -- and if it takes too long for that invoice to come around, they'll remind them.
And the accounts-receivable department at any major company you're working with isn't going to think any less of your company if it receives a letter or a call from a factor. They know all about factoring and accept that occasionally hearing from them is just part of doing business.
3
Factoring can be a useful predictor.
A bank decides whether you're a good credit risk and if they'll loan you money based on your financial past. A factor decides whether to advance you money based on your future. So if a factor is willing to purchase your invoices -- they see money in your future. They recognize, as you do, that things are looking up.
There's another way factors can offer insight: A reputable factor (like any organization you work with, you have to do your due diligence) will investigate the creditworthiness of any company that owes you money. If you're owed by a major corporation, then obviously your factor likely already has a file on it, and odds are, it isn't having money problems and your invoice will be purchased.
If you're owed by a smaller entity without a renowned reputation, a factor is a good way to discover whether you're likely to be paid. If your factor refuses to buy your invoice, you may be working with a company that's going to give you problems down the road.
There's another way factors can offer insight: A reputable factor (like any organization you work with, you have to do your due diligence) will investigate the creditworthiness of any company that owes you money. If you're owed by a major corporation, then obviously your factor likely already has a file on it, and odds are, it isn't having money problems and your invoice will be purchased.
If you're owed by a smaller entity without a renowned reputation, a factor is a good way to discover whether you're likely to be paid. If your factor refuses to buy your invoice, you may be working with a company that's going to give you problems down the road.
4
A plus: Factors assume most of the risk.
This isn't a loan. If you have a $50,000 order, and your factor initially gives you $37,500 (75 percent), and then somehow the major department store you're working with goes out of business and can't pay that $50,000 invoice, the factor is out the $37,500 that they paid you. Typically, you won't receive any more money from the factor -- that is, the remaining 25 percent minus the fee. But, again, you won't have to pay back the factor $37,500, and, of course, if you hadn't used a factor, you'd be out an entire $50,000.
5
A minus: Factoring comes with a cost.
If you're using a factor to handle all your invoicing, that's 2 to 6 percent of your business income you're ultimately losing. "Smaller businesses and entrepreneurs typically don't have a full understanding of the cost they're going to be paying," says Paul Hahn, a partner at Golenbock Eiseman Assor Bell & Peskoe, a New York-based law firm. "Smaller factors often charge higher rates, so the entrepreneur has to look at the impact of the cost of these funds over the long haul. You've got major companies with hundreds of millions of dollars that factor, and they do it because they don't have to have a credit department, so the commission they pay is more than offset by not having a credit and collection department." In other words, for many big businesses, factoring is a cost of doing business and, in a sense, outsourcing.
But if you're a small business that isn't invoicing hundreds of millions of dollars, factoring may not work for you. Like any business practice, you'll have to crunch the numbers. Also, consider hiring a company that offers invoice discounting, which is a very similar process to factoring -- one of the main distinctions is that any collecting is done by the small business. (Interface Financial Group is a franchise that does invoice franchising.) Because you're collecting, the charges for invoice discounting a little lower than factoring. And invoice discounters will usually advance you more of your money -- up to 90 percent -- than the factoring companies will.
Geoff Williams is a frequent contributor to AOL Small Business.
But if you're a small business that isn't invoicing hundreds of millions of dollars, factoring may not work for you. Like any business practice, you'll have to crunch the numbers. Also, consider hiring a company that offers invoice discounting, which is a very similar process to factoring -- one of the main distinctions is that any collecting is done by the small business. (Interface Financial Group is a franchise that does invoice franchising.) Because you're collecting, the charges for invoice discounting a little lower than factoring. And invoice discounters will usually advance you more of your money -- up to 90 percent -- than the factoring companies will.
Geoff Williams is a frequent contributor to AOL Small Business.
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Comments (Page 1 of 1)
I think two points always need to be brought out if you are talking "factoring" or discounts. First, if you give up something to pull in a payment and then you continue to give it up to keep pulling it in (there is a good chance you have to of you needed to do in in the first place)you keep paying to pull it in the first time. An extreme example is: Pull the same amount in for 3% for 33 times of factoring you gave up the gross on the whole order and all you did was move up the payment one factoring period. Second, most business/people look at the % for factoring/discounting as being very little, 2-3%, of the whole transaction or gross. But, the point is missed that it is calculated on the gross and the net is where you take the hit. For example, if you are working on a 20% net margin and you give up 2% for discounting/factoring you are giving up 10% of your net which is way too high.
To Gio: CC's and factoring are absolutly two different "beasts". The average % is a little over 2% (AmEx is the highest). You are getting in it in two business days (AmEx is longer - getting the trend on AmEx). It is there when it is suppose to be there and the always the correct amount - non-fail. It is an almost immediate entry in your check book - not 10 days, or fifteen, or wait for something to clear, etc... Now, what makes it a different beast is....You cannot be running a retail setup without having cc usage available. (A side note that makes me laugh - some retailers offer every card but AmEx because it is 1%). Now having it is almost, to make up a term, reverse marketing. You will lose too many sales by not having it. In response to your "Interruptions to orders" statement - that was one of the reasons I said extreme example - if there is a cycle nature (timing or amount) factoring has even less value. I still do not see where a company can benefit at all from factoring.
I'll pretend to be naive for a moment and ask, how is it that companies pay credit card discounts of 2-6% and it is so widely accepted but paying the same fee in a factoring transaction is both frowned upon and doesn't make sense? I understand (most of) the dynamics involved, the history, etc. But at the end of the day the benefits of cash flow acceleration, outsourced services, outsourced risk, etc. in credit card transactions are very similar to those in factoring transactions. And to Jimmilano's initial point, true, sellers collect in rears and the cash flow capital "catches up". But this only works if invoicing frequency and amounts are consistent on a month-to-month basis. Interruptions in orders, dramatic changes in order size, etc. can throw that model off quickly and put the seller in a cash flow bind. Grant it, factoring is not a fit for every commercial business out there. But there are a lot more companies out there that could benefit from from factoring that haven't looked at it as an option because of the stigmas associated (some deserved, most not) with it.
I want to clarify or comment on some of the information provided here:
1.) The comment is made about large businesses outsourcing and taking advantage of the credit work a factor does but fell a small business can't afford it ... yet I would see that as quite the opposite. How much would it cost to staff a credit manager when you can have a factor do it for 3 or 4%?
2.) Factors don't just see 'money in a companie's future' ... they do see invoices being paid BUT they only advance on invoices for customers that are strong payors. Of note: It is stated that advances are 75 - 80% (initial layout) HOWEVER that is totally dependent on the credit of the party paying the invoice. Of note here: Factoring propoosals read that a factor will advance "UP TO" and you better find out their credit policies and what "UP TO" means or you could be in for a tough time. Get it explained: It's your business and it's your money at stake!
3.) A third value added: Factors (we do any way) insure accounts receivables and include that in our pricing.
4.) A typical client is one that is turning away sales so when you start to look at giving up 2 - 6% if you do the actual math so long as the cost of factoring is less than the fixed operating costs of the business up through their break even point then if factoring opens the flood gates to additional sales it's like credit card processing opening new doors: It's smart business.
5.) As to the "all in" cost of factoring: I do a work up for any customer I work with and do a cash flow projection and cost projection ... and in any blog I have ever written I suggest that all business owners not just ask for it: But demand it. It's not rocket science ... and if you don't ask and you are surprised then my guess is that I would compare it to buying a car and overlooking the cost of registration, gasoline, maintenance, and who knows what else. Be assertive and ask and if a factor won't provide this for you be careful.
The real question? Are business owners in business to maximize sales and maxiize profits or are they in business to borrow cheap money?
In reply to Ebrown. Your honesty of working in the factoring business is nice to see but... Item "1" it looks like you have never had a business of your own. When there has been credit concerns in any company of mine I did not "staff a credit manager" - I sucked up the workload to get it done. (let's not get into the effciency benefits of doing this compared to an employee doing it. Nice line if you are selling factoring services - but your average competent business person will not buy it.
Items 2. You are knocking the business you are in. Yes, you are right you can only get money for an invoice to a "srong payor" and "UP TO". Then you add item 3 - which means nothing after what you say in item 2.
I must add at the point. I have never used factoring. But, I do not have to be a criminal do know that criminals are bad.....
Item 4. You have to be kidding. This must be part of your sales pitch. Factoring is the back-end of a sales transaction. Is does nothing to open the "flood gates to additional sales". It is nothing like credit card processing. I does nothing for marketing. It would be the last thing you would ever tell a customer you are trying to get business from. It does nothing to open the "flood gates" than just getting a cash injection and you are better off with a loan - it is not as "usury".
Also, what do you mean by "so long as the cost of factoring is less than the fixed operating costs of the business up through their break even point?" I will stick to the statement I made originally - "most business/people look at the % for factoring/discounting as being very little, 2-3%, of the whole transaction or gross. But, the point is missed that it is calculated on the gross and the net is where you take the hit. For example, if you are working on a 20% net margin and you give up 2% for discounting/factoring you are giving up 10% of your net which is way too high".
Also, what do you mean by "The real question? Are business owners in business to maximize sales and maxiize profits or are they in business to borrow cheap money?"
Another point. In very simple terms. To use factoring at even at a 2% charge is like paying 24% yearly interest on a loan. If you are doing that you will not be in business long - like I would expect most businesses that end up using factoring services.
In reply to Jimmilano: First off the intent of my posting was to open up some additional information.
True: I have not owned a business ... I've owned 11 of them and still own four of them and in case you'd like to know one of them has an LOI in hand and got to profitability using ... FACTORING ONLY and is totally - as in totally - debt free. Why? They never had to borrow.
As to having used or not used factoring: With three of them and soon to be a fourth I have used factoring. Why? You can capitalize the business without borrowing because factoring is not borrowing. FYI: One of those businesses fulfilled orders it could only have dreamed of fulfilling had it not used factoring. It's the one with the LOI in hand in fact.
Item 2: No. There is nothing being knocked in that statement and if someone feels or percieves that I was putting factoring down so be it. Factoring is a very defined process. IT IS NOT BORROWING NOR LENDING. Your alluding to criminals and not being one to know one. Huh?
Item 4: Factoring, like it or not, is actually a front end transaction that capitalizes a company withou their having to borrow. It's not complicated and only date back to the Eqyptians ... and still works. As to it not opening the flood gates? If you have a million dollars in invoices and cannot borrow against them nor convert them to cash your business (my businesses were any way until I factored) are dead in the water until you get in some cash. If you have some alternative to that then God Bless you. An invoice is a non-performing asset unless you can turn it into cash but I am sure that I'll stand corrected.
QUESTION: If you as a business owner could hire a sales person and they would help you access sales you otherwise could not BUT you had to pay them a 2% - 3% - 5% commission BUT they would increase your business 10 or 20 or 30% would you hire that person? If you say yes to this then you are endorsing factoring. It's not different than a credit card transaction. The business owner is selling the transaction to a third party to receive the payment so how is factoring different from cc transactions?
As to the cost of factoring? It appears that giving up 2% on the front end of a credit card transaction is okay (on a daily basis and using your formaula in your reply by the way that calculates annually to 760% by the way but we both knwo that this isn't true now don't we?). Why should a retailer accept cc processing? More business maybe? Larger sales? And what are doing? They are selling the transaction to the credit card company. Yes? No? FYI: I offer that service too ... not rocket science.
If you read what I said: Factoring should only be used by a company that is turning away sales and cannot grow otherwise and note: The only time that they factor is when they need working capital to fill an order that they would otherwise lose. It's like the sales commission: The only time you pay the salesman is when he sells i.e. it's a sale you either didn't have with the salesman or it's a sale you can't fulfill because your money if tied up in your invoices and you can't get it out.
That said it's pretty simple equation when you cannot access liquidity:
1.) Factor and give up 3% of the sale OR kiss off the sale and disappoint the customer and lose my profit margin ... 10%? 20%? 30%?
OR
2.) Factor and give up 3% of the sale OR kiss off the sale and disappoint the customer and lose my profit margin ... 10%? 20%? 30%?
OR
3.) Factor and give up 3% OR kiss off the sale and disappoint the customer and lose my profit margin ... 10%? 20%? 30%?
What part of being in business to maximize a profit am I missing?
As to the 24% annually(or as above it would be 36%) let's keep in mind that the owner of the business above got to complete tranactions that he or she otherwise wouldn't have been able to. Not a lot different than the retailer that get's to close a sale with a customer comes in with their cc is it?
Also please explain this: A bank loans someone money ($100,000) at 9% annually. A factor delivers $100,000 a month at a 2% discount and does this 12 times over the course of a year. Hmmmmnnn ... the bank delivered $100K for 9% BUT the factor actually delivered $1,200,000 for 24% so which is the better deal? The bank? It owns you: Invoices, inventory, equipment, your house and your signature ... the factor has a right to your invoices: End. Which is better?
Also: What happens with the bank when you need $200,000 and you are only approved for $100K? If you have invoices the factor funds you and yo make the sales and reap the profit ... the bank tells you, "Let's see how you do over the next year and come back" or the infamous reply, "We don't like your collateral and your credit is weak" and the bottom line is that they don't have ability to take the risk or perform the work that a factor does.
REMEMBER: MONEY IS NOT LOANED IN A FACTORING TRANSACTION. If you cannot accept or understand that then there is no sense in conversing any more on this ...
In closing: To correlate to the last statement that factoring at 2% monthly in discounted interest costs 24% in interest margins annually then I'll agree to that but only if it can be agreed that a company that sells product wtih a 30% monthly margin hereby makes a 360% annual profit to which you will scream back "They're not the same" and to that you'd be right: Factoring and borrowing money from a bank ... Are not the same.