Why entrepreneurs and small companies should consider factoring
Have you, as an entrepreneur and small business owner had difficulties in securing bank loans and credit lines or have you had to resort to private loans with high interest rates to meet your working capital needs?
If so, factoring can be a very valuable tool for your company.
Factoring is used when you can’t wait for your customer to pay you in their regular payment terms, since it will greatly affect your cash flow to operate your business. Also, some of your customers won’t offer quick pay terms or if they do, fees are high taking a large portion of your profit.
If you enter into a factoring relationship, you will sell your invoices for a discount to the factor. In turn, the factoring company will collect the full amount of the invoice directly from your Customer, when the terms are due. For example, ABC Company goes into a factoring relationship in which the fee charged by the factor is 3% per 30 days. ABC then sells $1,000 worth of product to their customer XYZ Store (which offers net 30 days payment terms). ABC will create an invoice for $1,000 and send the invoice to their factor that will bill XYZ Store and confirm the invoice. Once the factor has confirmed the validity of the invoice, it will pay $970 ($1,000 – 3% fee) immediately to ABC and the factor will then wait the 30 days to get paid from XYZ Store for the full amount of $1,000. Your operation will also benefit from this arrangement, since the factor will be in charge of the billing and collections processes.
In comparison to a bank, a factor shouldn’t check your personal or company’s credit score since the factor is mainly interested in the credit score of your customer, who at the end will be the company paying the invoice to the factor. Another advantage over traditional bank financing, is that you sell your invoices as needed and the factor’s fee will be taken from each invoice as opposed to a loan in which no matter the cyclicality of your business, you will be paying a set amount every month. Most importantly, your business does not have a limit in how many invoices it can sell to the factoring company, therefore there is no limit to how much you can grow. You can sell as many invoices to the factoring company as you are able to sell to your customers.
It’s important to note that if you decide to take the factoring route, make sure you understand if the factor you will work with is a non-recourse or a recourse factor. A non-recourse factor will assume the credit risk of your customers (will take any loss if your customer goes into bankruptcy) while a recourse factor will not assume the credit risk and you will be liable if your customer doesn’t pay. Usually a recourse factor will charge less since you will bear the credit risk, so you need to decide what will be more important, paying a lesser fee or having the peace of mind that the factor will assume the credit risk.
Lastly, factoring is truly an innovative product that goes hand in hand with your business cycle so take your time to select a factor that understands your business, challenges and opportunities and that will be committed to help you and your company grow.