All you ever wanted to know about factoring but were afraid to ask.

What is Factoring

Even if you have not heard the term, if you use a credit card, you are familiar with the practice
of factoring. When a merchant accepts a credit card for payment, it is willing to give up a
percentage (usually between 1.75% and 3.5%) of the amount due, in order to receive
immediate payment. The purchaser of goods pays the finance company (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. It is easy
to argue that the cost of this financing is built into the price of the product, but with heavy
price competition, it is getting more difficult to get away with this.

Factoring at this level involves the sale of accounts receivable (an asset) at a discount to a finance company. The finance company pays the business a discounted amount off the face amount of the invoice, and then receives payment from the customer.

The practice of factoring itself is as widespread as the companies utilizing this financing vehicle

Most new businesses fail to celebrate their five year anniversary. Although under-capitalization is usually blamed, often the real cause is poor cash flow. Factoring can alleviate the cash crunch suffered by start-ups as they grow to become more established businesses.

History of Factoring

Factoring has a long and rich tradition, dating back 4,000 years to the days of Hammurabi. Hammurabi was the king of Mesopotamia , which gets credit as the "cradle of civilization." In addition to many other things, the Mesopotamians first developed writing, put structure into business code and government regulation, and came up with the concept of factoring.

After a while, Hammurabi and the Mesopotamians went the way of extinct civilizations, but factoring endured. Almost every civilization that valued commerce has practiced some form of factoring, including the Romans who were the first to sell actual promissory notes at a discount.

The first widespread, documented use of factoring occurred in the American colonies before the revolution. During this time, cotton, furs and timber were shipped from the colonies. Merchant bankers in London and other parts of Europe advanced funds to the colonists for these raw materials, before they reached the continent. This enabled the colonists to continue to harvest their new land, free from the burden of waiting to be paid by their European customers.

Recognize that these were not banking relationships as they exist today. If the colonists had been forced to use modern banking services in eighteenth century England , the process would have been much slower. The banks would have waited to collect from the European buyers of the raw materials before paying the seller of these goods, the colonists. (And at that point, who needed the bank?) This was not practical for anyone involved. So, just as today, the "factors" of colonial times made advances against the accounts receivable of clients, enabling the clients to continue with their operations, long before they had been paid for what they were sold.

With the advent of the Industrial Revolution, factoring became more focused on the issue of credit, although the basic premise remained the same. By assisting clients in determining the creditworthiness of their customers and setting credit limits, factors could actually guarantee payment for approved customers.

Prior to the 1930's, factoring in this country occurred primarily in the textile and garment industries, as the industries were direct descendants of the colonial economy that used factoring so specifically. After the war years, factors saw the potential to bring factoring to other forms of invoice-based business and the expansion began.

Factoring became increasingly popular in the 60's and 70's and became well used in the 1980's. Banks on the other hand became more heavily regulated which created pressure for businesses to find other more creative and easier to obtain sources of funding or financing for the growth and profit of their businesses.

A Case Study

J & Sons, Inc. comes back from their annual trade show with some very big orders for its widgets. Of course their new customers want their orders ‘yesterday' so Mr. J starts evaluating the company's cash availability in order to place orders for raw materials. After some research, he realizes he has very little cash on hand; and that the funds are tied up in accounts receivables. He decides to talk to his suppliers and try to have them extend their credit limits and/or terms, but as he calls each of them, they not only deny his request, they actually ask him for payment because he is already 30 days overdue.

Mr. J suddenly recalls that he had met Mr. Factor at a networking meeting; so he finds his phone number and gives him a call.

As it turns out, J & Sons, Inc. has good receivables, and after a couple of days of due diligence, Mr. Factor purchases all the receivables. Mr. Factor advances 80% of the face amount of the invoices, and keeps the 20% balance as a reserve.

J & Sons uses these funds to order the raw materials, pay down on his supplier's credit lines (taking some discounts where possible), and, wanting to impress his new customers, produces the widgets in record time, since the funds are available to pay the employees overtime. As these orders get shipped, the invoices are generated and sold to the factoring company.

As the invoices get paid directly from the customer to the factor, the factor keeps its fee from the reserve, and then forwards the balance to J & Sons.

J & Sons now ends up increasing its sales, has acquired some new customers that are very happy with the product and the quick turnaround; and has put itself in a position where it can chase orders rather than chase the funds tied up in accounts receivables.

Factoring vs. Bank Financing

Factoring and bank financing utilize very different approaches when evaluating a potential customer; and have different ‘ideal' customers.

Typically, bank financing is concerned with ratios, cash flow, equity, collateral, credit and other issues. As anyone that has been through the application/approval process can confirm, it takes an extensive amount of paperwork and time to get a decision. The ‘ideal' customer has a stable business with predictable cash flow.

On the other hand, factoring is concerned with the quality of a company's receivables. The application/approval process usually takes only 3-5 days. The ‘ideal' customer is experiencing rapid growth and has quality account debtors with no concentrations.

Factoring is very valuable for companies that are experiencing rapid growth. A factoring company can purchase a company's receivables as fast as the company can generate the receivables. Factoring is also utilized when a company and/or its principals have some derogatory credit background.