Factoring
Factoring is the sale of accounts
receivable. By selling your invoices for future payment, you
generate cash sooner than if you collected the money on your
own. The factor company that purchases your receivables takes
title to the invoices and collects them when they are due. That
company also assumes responsibility for all of the costs, as
well as the hard work and hassle that comes with customer debt
collection.
Commercial finance
companies, some banks,
and a variety of different types of financial companies will
purchase receivables. For businesses with relatively small
monthly amounts of receivables (e.g., less than $10,000), it may
require some effort to locate a factor company willing to
purchase those receivables. Your local telephone book may list
factoring "brokers" that can assist you in locating
suitable factor companies.
The downside to factoring is that it's not cheap; the cash
price of accounts receivable is discounted by the factor
company. Your final cost will nearly always exceed the amount
paid as an interest rate on a short-term commercial loan for an
equal amount. Moreover, because factoring requires accounts
receivable, it is usually limited to existing businesses.
Most commonly, factoring is used by rapidly growing
businesses ($125,000 to $10,000,000 in annual sales) that face
temporary cash flow problems. Except in certain industries, such
as the garment industry, factoring is not used on a long-term
basis.
The advantages to factoring include:
- Quick cash: You can receive quick payment in cash
after the time of shipment, delivery and invoicing a
customer. This immediate payment for invoices nearly
eliminates the sale-to-collection business cycle and allows
businesses caught in a cash crunch to obtain fast relief. If
a relationship with a factor already exists, turnaround on
the sale of receivables should take only about 24 hours.
When making a first-time purchase of invoices from a
business, factors typically take one to two weeks to check
the credit ratings of the customers and communicate a
discount price.
- No debt: Factoring is a sale of assets
(invoices), not a loan. For businesses that either cannot
qualify for traditional debt financing or that simply do not
want to incur more debt, factoring is good alternative means
of financing.
- Eliminates collections: Most factoring is called
"nonrecourse," meaning that the factor company
purchases all rights in the invoices and the seller has no
responsibilities for collection. The factor's anticipated
cost and time in making collections is computed into the
discounted purchase price of the receivables. In some
states, however, "recourse" factoring is also
permitted. In recourse factoring, you are secondarily liable
for any invoices not collected. The factor company
undertakes debt collection, but you remain ultimately
responsible to repay any portion of the cash price
attributable to an account that went uncollected.
The disadvantages to factoring are:
- Cost: Traditional loans will typically be less
expensive than the costs of factoring. The upfront cash
price for accounts receivable is typically 70 percent to 90
percent of face value, depending upon the credit history of
the customers and the nature of your business. The initial
price is treated as a cash advance and you typically receive
an additional portion of the face value when (and if) the
accounts are collected. Your final price is usually between
90 percent to 95 percent of the original invoice amount. The
longer the invoice period, the higher the rate. Most factors
will not take invoices with longer than 90-day payment
periods. In addition, the credit history of the customers
can affect your final costs.
- Possible harm to customer relations: Collection
actions taken by the factor company may endanger an ongoing
business relationship with one of your customers. In a small
business, there may be circumstances in which you would
compromise a debt, extend payment deadlines to a preferred
customer, or employ a more lenient collection approach for a
specific customer. A factor company has little interest in
preserving your future relationship with the debtor and some
companies may be overzealous in collecting receivables.
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Factoring agreements can be quite flexible,
and you should always negotiate for the best
terms possible. Renegotiation for a lower
discount percentage is common in ongoing factor
relationships; however, the most negotiable
charges are often not the initial discount
percentage, but other additional charges (such
as a fee for expedited wiring of your cash price
or an initial user fee) assessed by most factor
companies.
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