Does your company sell goods or services to other companies or government agencies? If the answer is “Yes” chances are that the current economic climate leads to a waiting period of 30, 60 and sometimes even 90 days until you get paid by your clients. Waiting to be paid by your clients can be very challenging – if not detrimental – especially if your business is a start-up. But even if your business has been around for a while getting paid fast – usually within one day – can help provide the capital to expand and the cash flow to pay employees, suppliers, rent, and other expenses.
Because not every business person is familiar with factoring I thought it would be a good idea to elaborate on this forgotten sector in the world of financing . So what is factoring then? Factoring is the selling of a business’ accounts receivables in order to secure immediate working capital. Through factoring its invoices a business eliminates the uncertainty of when it will be paid, allowing for better management and planning. For example, let’s say ABC Pavement has a contract with the local municipality to re-pave all damaged roads in a specific town. ABC learns that it takes 30 to 60 days for the government agency to pay for the work provided yet employees and other expenses must be paid right away. To streamline the efforts and work more efficiently, ABC then sells its invoices to the factoring company. By doing that ABC is now able to secure advance payment on its invoices usually within a day or two in comparison to 30 or 60 days.
Of course factoring is not limited to businesses providing services to government agencies. Manufacturers, Distributors, and Wholesalers can usually benefit from such transactions. Upfront capital could be used for payment of suppliers, employees, and new orders. More business sectors enjoying such benefits are the Staffing companies, Transportation, Oil Field Service providers and a variety of other service providers.
So one may ask how does factoring work, how long does it take, what are the usual requirements. Let’s say Lena’s Staffing Agency provides a local employer with qualified temporary employees. Lena normally would have to wait 45 days to get paid by the client (employer) but Lena has expenses that need to be met including the temporary employees’ salaries. Instead of waiting 45 days to get paid Lena contracts with a factoring company and every time she invoices the client she gets immediate working capital to run her business. The factoring company will buy Lena’s invoices and pay her in two installments. The process goes like this. After she gets approved, Lena invoices her client (the local employer) and sends a copy of the invoice to the factoring company. The factoring company advances the first installment of anywhere between 70% to 90%. Once the client pays the full invoice, the factoring company rebates the remaining 10% to 30% less the factoring fee.
The general criteria for approval is for Lena to contract with clients that have a reasonably good track record of payment and her invoices to be unencumbered (free of liens or judgments). It’s all about risk, factoring companies like any financial institution will determine how much risk, if any, are they willing to take. After all, why buy an invoice that has a high likelihood of not being paid? Because the level of risk can vary based on the client, field and/or local economic factors, the advance installments and the monthly rates can vary, as well. And finally, the factoring of invoices comes with a full recourse or non-recourse clause. Full recourse is the plan under which your business is liable for any factored invoices that cannot be collected from your client. In a non-recourse situation your business may not be liable, however it is rather difficult nowadays to find factoring companies that would take that kind of risk. So be prepared to assume this type of responsibility.
Last on my list is evaluating whether factoring is truly an enhancement for your business or not. Because factoring companies do charge a fee to buy your business invoices you’d have to determine whether payment of such fee is justified. This is something that you, as a business owner, would have to analyze. Of course, to determine what fees you’d have to give up to get upfront working capital on your invoices you may want to first speak with a factoring company. Then you’d have to figure out how much (or how little) you’d gain by having access to immediate capital. If you have experience with factoring it would most likely be a fairly easy assessment for you. But if you’re new to factoring and still don’t know whether it would be a benefit you may decide to do a limited trial period, say anywhere between four to six months. If it turns out that your business becomes more efficient, you found your solution. But if it’s not then you can always go back and operate under your original business plan.