What You Need to Know About Financing Your Business - Financing 101: Factoring
Factoring probably isn’t the first financing tool that you think of when figuring out how to finance your business. In fact, it is probably a tool that many people haven’t even heard of in North America, although it is commonly used in Europe. Factoring is one of the oldest forms of financing, originating in the middle ages, factoring was how financiers financed the voyages of the merchant adventurers enabling them to purchase trade goods to trade for goods in foreign locales. They achieved this by advancing funds against the possibility of future profits. The risk was that something could happen on the voyage in which case the financiers would lose their investment.
Without realising most people are exposed to factoring on a daily basis. The credit cards you are using are form of factoring. For a fee (called merchants fees) the merchants accepting credit cards are transferring the risks of granting you credit to the credit card company (the factor). The credit card company (the factor) assesses how much risk they are willing to carry on you (the equivalent of how much they are willing to carry of any particular company’s accounts receivable) and this is your credit limit on your credit card. The only difference is that you are charged interest on your outstanding balance, which the companies whose receivables are being factored are not. So, what is factoring?
Factoring is the purchase of accounts receivable at a discount. A common discount rate used in factoring is 9%, although lower and higher rates can be found. To see this in action, if you sell an accounts receivable for $100 to a factor then you would receive $91. This is the first important point to note about factoring. They use discount rates and not interest rates. Whether your accounts receivable is outstanding for 30 days or 60 days, the discount rate stays the same and is charged once when the accounts receivable is purchased. Accounts receivable are purchased on either a ‘recourse’ or a ‘non-recourse’ basis. If they are bought on a recourse basis, then this means that if the company who owe the money on the receivable don’t pay, then the business selling the receivable have to make good on the full amount of the outstanding accounts receivable or replace it with others of equal value. Without recourse means, that the factor is so confident that the company owing payment under the account receivable will pay that the factor is willing to accept the risk of non-payment without passing that risk on to the person selling that receivable to them.
A couple important points to keep in mind:
Factoring companies usually only accept accounts receivable which are less than 90 days old. Once they reach 90 days if you are on a ‘with recourse’ basis you will now have to either redeem the 90-day old receivables for the face amount, not the discounted amount, or replace them with another accounts receivable which is less than 90 days old or ones’ of an equivalent amount.
Ensure that you have sufficient gross margin to cover the cost of factoring. Referring back to the above example if your gross margin is less than 9% then you will not make money and are selling your goods at cost.
The next thing to know about factoring is that it is primarily based on the credit rating of the company owing the money and not the person owed the money. Contrast this with a bank where priority would be on the credit worthiness of the person borrowing against the accounts receivable. This means that factoring is ideal for companies still working on establishing their credit rating. The factor evaluates the company owing the money and for larger companies may allocate a maximum amount of risk it is willing to carry on that company which may result in them sometimes refusing to accept some accounts receivable if they reach the maximum amount they are willing to carry. If you get an outright rejection it is usually a good indication that the credit worthiness of the company is suspect and you should guide your future actions accordingly. The reason why they pay so much attention to the people owing the money rather than on the people owed the money is that payment under the accounts receivable is made direct to the factor not to the person originally owed the money.
Let’s look at the advantages of factoring. First off factoring gives you instant access to cash. Instead of having your money tied up for up to 60+ days in sales you have already made, factoring provides you with the cash to go out and buy more inventory or raw materials to make more goods immediately, thus providing you with the means to ramp up sales more quickly. This is particularly advantageous for newer businesses that are short of capital to grow as well as companies experiencing rapid growth who need to access cash to support that growth. While the optimal way to support this growth is still to inject additional capital, factoring can act as an interim step. Additionally, factoring can assist companies that are encountering financial difficulties by providing that extra cash to provide them with the resources needed to put the company back on an even keel.
Some key points you should be aware of:
You cannot factor your receivables if they have been assigned to a bank or another lender. Most banks assignments of receivable agreements have a clause which refers to “Accounts Receivables now owned and to be acquired”. This means you cannot claim that new receivables are not covered by your legal agreements with the bank.
In some circles, in Canada particularly, factoring has a negative connotation. Some perceive that companies that use factoring are in trouble instead of realising that this is just another form of financing, which when used correctly is a very valuable form of financing. Also, some companies do not like factoring because they feel that it causes problems within their accounting systems because now instead of paying the supplier or company that provided the service, they now have to pay the factoring company.
If you factor your accounts receivable, it is just like selling any asset in your company. You have exchanged your receivable for cash and only the cash you received should appear on your balance sheet, not the receivable that you sold.
In the right circumstances factoring can be a valuable component of your financing mix and is one that should be seriously considered when building your financial plan, particularly if you are a new business or one growing exceptionally quickly. If you have any questions or require more information, do not hesitate to contact us at firstname.lastname@example.org.
The next blog in this series will look at grants and special interest group loans (e.g. Young entrepreneurs, Clean-tech, etc.).