Factoring: The Forgotten Form of Financing
In today’s post Covid lockdown environment, many small and medium sized businesses are having trouble getting conventional financing because of the current financial strength of their businesses and the impact the lack of sales has had on their credit ratings. How would you like a form of financing that did not depend on your credit rating but rather your customers credit rating? In a nutshell that is factoring.
In North America, factoring has an undeserved negative image and is associated only with businesses in trouble. Contrast this with Europe, where it is perceived as a practical everyday way of financing a business. In actuality, factoring has been around for hundreds of years and was how merchants financed their ventures from the 16th century on. They gave the captains of the merchant ships the money to go purchase the goods that they wanted to buy. The captains would go buy the goods for the merchants and take a commission for doing this.
So, how does factoring work today? Let’s say you have an invoice for $100,000 and it will be paid in 45 days time. If the client’s credit is good, then the factor will purchase the invoice from you. Factors do not charge interest; they discount the value using a rate that typically varies from 2 to 9%. So, if the factor we use uses a discount rate of 9%, that means we will get $91,000 immediately. But you say my bank only charges 5% per annum interest. That is if they will give you the money and banks typically do not like to advance more than 60% of outstanding invoice amounts.Think of factoring this way. If my gross margin is 30%, then if I invest this $91,000 in inventory that I sell quickly then I make an additional $27,300, which is more than enough to offset the $9,000 charged by the factor. This is the advantage of a financing method that focuses on providing you with instant cash flow.
Some important facts to know about factoring. Factoring comes in two forms. One is ‘With Recourse’ and one is ‘Without Recourse’. With recourse means that if the factor is unable to collect the receivable for any reason, then you have to replace it with one of equal value or return the money you were paid. Without Recourse is used when your client has a very good credit rating and means that your factor accepts the risk and if they are unable to collect the amount, they accept the loss.
Factoring cleans up your balance sheet and shows a very positive working capital position and as a result many businesses find that after 6 months of factoring their receivables, their balance sheet has been cleaned up to a point where more conventional forms of financing are available to the business. For international trade, the equivalent of factoring is known as Forfaiting.
Factoring is not a tool to clean up you bad debts. Remember it is based on your client’s credit rating and if it is already a bad debt it is unlikely to qualify for factoring; Factors prefer their receivables to be under 60 days.
Factoring is not for everyone but it is a tool you should be aware of.
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