What is Factoring?
Factoring is a promising way to stimulate the cash flow of a company. Its growing popularity can be gauged from the statistics that factor finance approximately amount to $70 billion in the United States each year.
However, before leaping on the factoring bandwagon it is important for the business owner to know what makes a business suitable for factoring:
- Before making any decision the owner should have a list of his customers and they should be in sufficient number
- No customer should contribute over third of the turnover
- Customers are needed to accept the standard payment terms of the industry.
- Period of credit given to the customers should be reasonable
The following factors make a business unsuitable for factoring:
- When there are too many small invoices
- Factoring is unsuitable when it is sold to the public. It is only available for sales to commercial customers
- There is a provision for the customers to make part payments
- When there are many disputes and queries
- The business is not reliable, credible and sound in its operations
It is very important for the business owners to have a good understanding of these factors as they will be sharing important financial information of their business and will be in direct contact with the customers too. Earlier factoring was not widely used due to the ignorance of business owners regarding the benefits factoring could bring in to the company. Thus it is important for every business owner to be aware of benefits of factoring before using it in their business.
Factoring Fundamentals: Vendor Financing
Factoring is an efficient and reliable way of meeting capital needs of the business. It is beneficial when a business promises to have definite profits in future but faces capital deficit to get the project completed.
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The principles that govern factoring are same as those governing bank loans, credit cards, and other such lending methods. The basics of factoring are divided into two main practices.
When a factor purchases an estimated value of the future account receivables it is known as non-recourse factor practice. In non-recourse factoring, the factor bears the bad debt risk and the business owner is required to pay interest to the factor for the period specified in the factoring agreement. Many national banking institutions offer this as well as smaller firms.
The second full-recourse factor practice involves the use of invoice as a security to make a loan. In recourse factoring, the factor has recourse to the business owner if the concerned customers do not pay. Recourse factoring is cheaper than non-recourse factoring.
How Does Factoring Work?
The first step in the process is to fill the documents provided by the factor and when they get completed the factor provides the business owner with cash against receivables.
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The factor then pays the business owner a certain percentage of the total value of your invoices. This can be up to 90% of the total value of the invoices. This is paid as soon as the invoices are received, or at the time agreed upon between the business owner and the factor. The process normally takes 24 hours to complete and is either sent directly to business owner s account or through the mail.
Once customers pay the bills at pre-determined dates lenders to pay up the remaining amount. In the end business owner will also receive copies of customer checks on the date of receipt to keep a record.
Factoring fundamentals once confirmed and acknowledged, are a step towards a stable and secure business, as they help in keeping the working capital needs of the company on track.
The Pros and Cons of Factoring: Trade Receivables
Factoring is a quick and easy way to replenish your business with urgently needed cash in quickest possible time. However, this financing option is not all hassle free and has its disadvantages too.
- It is the quickest way to get advance cash.
- Overhead charges get automatically reduced with the cut in invoice processing activities.
- The business owner becomes free of various other obligations connected with the invoice processing like depositing checks and entering payments.
- Getting cash with factoring helps in eliminating the risks of bad debts.
- By undertaking the task of debt collection it helps the company in concentrating on more value added activities.
- Without acting as hindrance to cash flow it gives an opportunity to offer credit terms to customers.
- Factoring brings no extra liability in balance sheet and hence does not result in creating hassles while obtaining other types of financing.
- Early payment discount is another benefit of factoring. Payment of bills before the scheduled time brings in many benefits in the form of discounts.
- It is an easy way to have an access to unlimited capital as with an increase in sale more money becomes immediately available to business owners.
Some other benefits include building credit, quick and easy process, concentration on marketing and securing new accounts and no long-term obligation.
- The biggest disadvantage is it makes the process complicated as it acts as an extra link in the process.
- It is useful for companies with disputes and queries.
- The ambit for borrowing gets narrowed, as account receivables will not be available for security.
- Factors may want to get your customers examined and may have influence over your ways of doing business.
- In case the customers do not repay the money, you have to pay their amount entwined in factoring.
- It is costly than other sources of finance though it is competitively priced.
- Few customers don’t want to deal with a third party and are not interested in factoring.
Comparing Factoring to Other Financing Options
There are a number of financial options in the market and you need to analyze each in detail to determine which suits you the best. A business can be financed with help from private investors, lenders and financial institutions depending on your needs and priorities.
Varied Commercial Financial Options Credit Lines: In this the lender is actually a bank. The bank gives credit lines to fill the temporary shortages of business like inventories, receivables etc. These shortages are mostly due to the time difference between the payouts and the collections. Unlike factoring, financing through credit line requires a good credibility record along with the collateral. Banks also require business owners to maintain the obligatory balance of funds in their accounts.
Short-term Loans: As the name suggests these are the loans that are sought for the term of a year or less and are generally secured. They are taken to meet expenses like insurance or to cash over the discounts offered by the supplier and are mostly paid back in the lump sum at the maturity.
Asset-Based Loans: Similar to factoring, asset-based loans are raised on current assets like inventory or accounts receivables. However, its ambit goes wider to include varied current assets while in factoring it is limited to account receivables. The lender has a security in the assets of a company and is mostly sought to meet the working capital needs.
Contract Financing: In this kind of financing funds are advanced in accordance with the work performed till date. Criteria on which finance are provided under contract financing is the credibility of business to complete a contract and its ability to perform. Under this contracts are used as collateral to get short-term loans. When it is difficult to obtain finance through banks factoring is a promising option. The method also relieves small companies of the expenses involved with the collection of receivables. It is not a one-time transaction and is generally provided on a contractual basis.
Howard Schwartz is a partner in several business strategy groups, including HJ Ventures International, Inc. Howard has worked with hundreds of entrepreneurs worldwide with a focus on writing Business Plans for companies interested in raising capital from Venture Funds and Angel Investors. Howard’s business plans have secured several million dollars in funding. For more information: http://www.hjventures.com/factoring/factoring-glossary.html
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