Factoring advantages and disadvantages
/Factoring is a financial transaction in which a business sells its accounts receivable to a third party (known as a factor) at a discount in exchange for immediate cash. Invoice factoring can be quite a useful source of cash for smaller businesses that are having trouble procuring a loan. These businesses typically have reasonable margins and are trying to grow their sales, but do not have sufficient collateral to post against a loan, or enough operating history to gain the confidence of a banker.
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Advantages of Factoring
There are multiple advantages associated with factoring your accounts receivable. In the following bullet points, we summarize many reasons for doing so:
Reduced application time. The time required to establish a relationship with a factor is relatively short, and certainly less than is required to obtain a bank loan. A normal account setup time is anywhere from two days to two weeks. Thus, if you are in a hurry to obtain cash, factoring is a good choice. In addition, there is no additional application process when you submit additional invoices to a factor for reimbursement.
Processing speed. Once a business has been set up with a factor, it is quite easy to obtain cash by forwarding additional invoices to it. Factors can pay within 24 hours of invoice receipt, though 48 hours is more common. This differs from a banking relationship, where each individual borrowing requires an additional loan application (though this is not the case with a line of credit).
Debt avoidance. The use of factoring eliminates or reduces the need for debt financing. Since the business is essentially selling its receivables on-the-spot for cash, there is no obligation to make a repayment to anyone at any point in the future. This minimizes the firm’s fixed expenditures, since there are no scheduled debt payments.
Balance sheet de-leveraging. Since factoring involves the avoidance of a debt obligation, no debt related to this arrangement appears on the client’s balance sheet. In addition, the nearly-immediate conversion of receivables into cash makes the business appear more liquid. These factors give a client’s financial statements a more robust, debt-free appearance.
Credit rating enhancement. When a factoring relationship accelerates inbound cash flows, a business is in a better position to pay its bills on time. When this is the case, the firm will likely see a gradual improvement in its credit rating over time.
Minimal credit strength needed. In a factoring relationship, it does not matter if your business has a rather wobbly financial standing. Instead, what matters is the quality of its customers. As long as there is a minimal risk of bad debts associated with your customers, you can likely sell the firm’s receivables to a factor.
Selectivity. There is no need to sell every invoice to a factor. Instead, you can forward only a selection of invoices to this party, usually ones that are larger and for which payment tends to take longer. Smaller invoices and those for which payment is received sooner may be retained, depending on your cash flow situation, in order to avoid paying the factoring fee.
Collection assistance. Factors can be quite good at payment collection activities, sometimes to such an extent that they are essentially taking over the bulk of all collection procedures from its clients. This can be an exceptional benefit for those clients that do not have an in-house collection staff.
Happy suppliers. When a business uses factoring, it is much easier to maintain a reasonable cash balance at all times. This means that the firm can, in turn, pay its suppliers on time. Timely payments translate into good credit, so that suppliers will be more willing to advance additional trade credit to the company.
Early payment discounts. When factoring results in a moderate amount of on-hand cash, a firm can even take every early payment discount offered by suppliers. These discounts tend to have quite large effective interest rates associated with them, and so are an excellent deal.
Business investments. With the extra cash provided by factoring, a business can invest more in operations, perhaps by expanding its advertising budget, increasing its inventory offerings, or acquiring more fixed assets.
Availability in down cycles. When there is a downturn on the economy, banks will probably start cutting back on the amount of lending they do, in order to minimize the risk of defaults on outstanding loans. This is not the case with factors, who are only interested in whether a client’s customers can pay their bills. As long as this is the case, obtaining cash from factors during a down cycle should not be a problem.
Undivided ownership. If a key concern is maintaining ownership of your business, then you may need to use factoring, if only to avoid selling off a portion of the business to outside investors in order to raise cash. After all, factors do not seek an ownership position in your business.
In short, there are many reasons why factoring can work for a business. However, there are also some downsides, as noted next.
Disadvantages of Factoring
Though the preceding list of factoring advantages is fairly long, there are also a number of important issues that can make it a less-than-ideal choice for some businesses. We note these issues in the following bullet points:
Due diligence fees. A factor may pass through the costs it incurs to conduct due diligence on your company – which may be required in advance. These fees cover the cost of running credit reports on your company and its customers (which can add up to a noticeable amount), public records searches for UCC filings, tax liens, and bankruptcies, a criminal records search, and an asset search.
Cost. The size of the discount required by a factor tends to be relatively high, though this amount will vary, depending on customer creditworthiness, the size of the invoices being repaid, and how long it will be before the customer pays. You should certainly expect a minimum discount of 3%, which can go up when your customers are of lower quality or your invoice volume is relatively low. In addition, the discount taken by the factor is based on the face amount of the invoice, not the amount of the advance; this increases the percentage amount of the discount.
Advance size. If your customers are of lower quality, factors will only agree to a smaller percentage advance on the invoices issued to them. For example, an invoice issued to a Fortune 500 company might result in a 90% advance, while a construction receivable might only yield a 50% advance. Some factors will offer a higher advance, but charge a much higher discount, such as a 90% advance and a 10% discount (which means that there is no rebate).
Customer quality. Factors are more willing to buy the receivables of high-quality customers. Therefore, if you are doing business with lower-quality customers, there may be no factors interested in doing business with you – or who will want to charge an exceedingly high fee because of the risk of customer nonpayment.
Invoice volume. If your business is quite small, it can be hard to find any factors willing to do business with you. Factors need a certain amount of volume in order to earn a profit, which is difficult when you are only generating a few thousand dollars’ worth of invoices per month.