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Factoring

Factoring is a word often misused synonymously with accounts receivable financing. Factoring is a financial transaction whereby a business sells its accounts receivable (i.e., invoices) at a discount.

Factoring differs from a bank loan in three main ways.

  • First, the emphasis is on the value of the receivables, not the firm’s credit worthiness.
  • Secondly, factoring is not a loan – it is the purchase of an asset (the receivable).
  • Finally, a bank loan involves two parties whereas factoring involves three.

The three parties directly involved are: the seller, debtor, and the factor.

The seller is owed money (usually for work performed or goods sold) by the second party, the debtor. The seller then sells one or more of its invoices at a discount to the third party, the specialized financial organization (aka the factor) to obtain cash. The debtor then directly pays the factor the full value of the invoice.

Reason

A company sells its invoices, even at a discount to their face value, when it calculates that it will be better off using the proceeds to bolster its own growth than it would be by effectively functioning as its "customer's bank." In other words, it figures that the return on the proceeds will exceed the income on the receivables.

Differences from bank loans

Factors make funds available, even when banks would not do so, because factors focus first on the credit worthiness of the debtor, the party who is obligated to pay the invoices for goods or services delivered by the seller.

In contrast, the fundamental emphasis in a bank lending relationship is on the creditworthiness of the small firm, not that of its customers. While bank lending offers funds to small companies at a lower cost than factoring, the key terms and conditions under which the small firm must operate differ significantly. Bank relationships provide a more limited availability of funds and none of the bundle of services that factors offer.

From a combined cost and availability of funds and services perspective, factoring creates wealth for some but not all small businesses.

For small businesses, their choice is slowing their growth or the use of external funds beyond the banks. In choosing to use external funds beyond the banks the rapidly growing firm’s choice is between seeking angel investors (i.e., equity) or the lower cost of selling invoices to finance their growth. The latter is also easier to access and can be obtained in a matter of a week or two, versus the six months plus that securing funds from angel investment typically takes.

Factoring is also used as bridge financing while the firm pursues angel investors and in conjunction with angel financing to provide a lower average cost of funds than would equity financing alone.

Firms can also combine the three types of financing, angel/venture, factoring and bank line of credit to further reduce their total cost of funds. In this they can emulate larger firms.

As with any technique, factoring solves some problems but not all. Businesses with a small spread between the revenue from a sale and the cost of a sale, should limit their use of factoring to sales above their break even sales level where the revenue less the direct cost of the sale plus the cost of factoring is positive.

While factoring is an attractive alternative to raising equity for small innovative fast-growing firms, the same financial technique can be used to turn around a fundamentally good business whose management has encountered a perfect storm or made significant business mistakes which have made it impossible for the firm to work within the constraints of a bank line’s credit terms and conditions.

The value of using factoring for this purpose is that it provides management time to implement the changes required to turn the business around. The firm is paying to have the option of a future the owners control. The association of factoring with troubled situations accounts for the "half truth" of it being labeled 'last resort' financing. However, use of the technique when there is only a modest spread between the revenue from a sale and its cost is not advisable for turnarounds. Nor are turnarounds usually able to recreate wealth for the owners in this situation.

Large firms use the technique without any negative connotations to show cash on their balance sheet rather than an account receivable entry, money owed from their customers, particularly when these show payments being due for extended periods of time beyond the North American norm of 60 days or less.

See RECIVABLE FINANCING