Factoring Myth #3: Factoring is just like a bank loan
Business owners (and sometimes accountants) confuse factoring with “borrowing” money – as with a traditional bank loan.
In reality factoring is nothing like a bank loan. Here are three reasons why:
- With a bank loan you “borrow” money that must be paid back thus creating a “liability” on your books. Factoring is a “buy and sell” relationship: You sell an asset called Accounts Receivable. In essence you are moving the asset value from the A/R column to your Cash column. There is nothing to “pay back.”
- A bank loan involves two parties: you and the bank. Factoring involves three parties: you, your customer and your factoring company. Here’s how the 3-party transaction works: When the factoring company (party 1) buys an invoice from you (party 2) they now own the right to payment. Your customer m(party 3) is then notified to send the check to the factoring company – not to you.
- In a loan the bank is most concerned with your credit rating. In factoring, the most important consideration is your customer’s credit rating.
These three points make factoring a unique and highly flexible tool for accessing working capital.
Factoring Myth 2: Factoring Fees are much more expensive than bank loans
The insidious myth
This myth is insidious and causes many business owners who could benefit from factoring to discard it as a means of finding working capital. To bust the myth, think in terms of the how you get paid for your product or service.
Cash flow example
Let’s say you own a manufacturing company that produces 1000 green gizmos for your customer, Company XYZ. The payment cycle goes like this:
- Manufacture
- Ship
- Invoice
- Wait for Payment
Let’s say the invoice is $10,000. That amount show up in your financial records as “Accounts Receivable;” that is, money owed but not yet collected.
Factoring fee vs bank interest
When you sell that invoice to a factoring company they will discount the value of the invoice by a certain percentage, but you get the immediate use of your money. You don’t need to wait 30 days or more. That discount will typically range from between 3% and 6% – depending on a number of variables. (This is similar to the range of credit card merchant fees.) For purposes of this example we’ll assume a fee of 4% of the face value of the invoice.
If you have ten customers each of with buys 1000 gizmos in January. You will have 10 separate invoices each for $10,000 or $100,000 gross volume. You can sell each individual invoice to you factoring company and you will pay the same fee for each invoice: 4% of the face value. If you factor $100,000 in invoices every month for 12 months ($1,200,000) you will have paid 4% of the face value as a fee.
Confusion with a Bank Line of Credit
Many people confuse the factoring purchase fee with a revolving line of credit. They mistakenly calculate that at 4% per month you are paying 48% annualized interest on $100,000. But you didn’t receive $100,000. You received $1.2 million.
But let’s take this one step further. If you have a bank line of credit and it is always at $100,000 of funds drawn, you would be paying something like 3% or 4% per month on the unpaid balance anyway. So one way or the other, the factoring fee is not as high as most people mistakenly believe.
Busting the Mythys About Factoring – Part 1
A “myth” is defined as “any invented story, idea, or concept.” In the realm of factoring, there are three primary myths which, in my observation, have caused people who should know better to overlook this useful and powerful financial tool for business. I will address these myths in a three part series.
#1 Myth in Factoring: Factoring sends a signal your business is in trouble
This myth stems from the fact that many business owners do not closely monitor their cash situation. Because they do not analyze trends and take preemptive action, they are surprised by serious cash shortfalls that jeopardize their business. When they finally do ask for help, they’re already near default or close to closing their doors. Consequently they can’t qualify for a bank loan or line of credit and the only option left for them is selling their invoices to a factoring company.
Two more reasons this myth persists:
- Most branch-level banking personnel do not understand the factoring model and how it can benefit both their customers and their bank; and
- Some CPAs and accountants mistakenly equate “factoring” with the type of “pennies on the dollar” transactions seen in a distress sale situation.
In truth, factoring is a financial strategy that can leverage the growth of a business. (See my earlier blog postings for more detail.)
Furthermore, it complements a bank’s relationship with its business customers by keeping money in the checking account. It can maintain the health of the business during times of stress (like rapid growth or general economic constriction).
In addition, factoring is not a “pennies on the dollar” transaction. Most businesses will offer their customers a discount for early payment of an invoice – anywhere from 2% to 10%. But the reality is that the customer will all too often demand the discount and pay in 30 to 45 days anyway. As a result, you decrease your revenue without the advantage of having access to your money.
Factoring guarantees you immediate access to your money. And it does so for a discount rate in that same range as an early payment discount.
The bottome line? Far from being a sign of weakness, factoring is an indication that the business owner understands all his/her options and is using the financial tool that best suits his or her current position on the cycle of business.
Finding Cash at Warp Speed
The two primary sources of operating capital for a business are:
- Cash from sales; and
- Borrowed money (typically from the bank).
In today’s economy customers are pushing out payment dates and banks are STILL not lending.
This can create tremendous pressure for you because your suppliers, employees, etc., are expecting to be paid NOW.
Factoring your Accounts Receivable is an alternative source and one of the fastest avenues to immediate cash. If your company has commercial accounts there’s an excellent chance you can get a cash infusion in 3 to 5 business days.
As a financing tool, factoring has been in use for centuries. It gives companies, large and small, an off-books way to manage cash flow situations. Use the process once or use it every month – whatever best suits your situation.
If you don’t know anything about factoring, take the time to learn.
Surviving the Economic Storm of the Century
The economic downturn and credit crunch have caused banks to reduce access to business loans and rescind lines of credit. To compound the problem, many companies (possibly your customers) are taking longer to pay on invoices. And yet you are expected to make payroll, pay taxes and settle up with suppliers NOW!
In this perfect storm of economic turbulence, how do you survive?
The answer may lie in the use of the “factoring” model for Accounts Receivable Financing – a funding service used by Fortune 2000 companies but that, oddly, is relatively unknown in the small and medium size business market.
What is Factoring?
“Factoring” is a purchase and sale transaction between your company and the funding agent – the factoring company. It is neither a loan nor a traditional line of credit. It is the sale of a specific financial instrument (an invoice). Consequently it gives you immediate cash without creating an offsetting liability on your balance sheet. It moves you’re A/R asset (which depreciates over time) into the cash column.
Factoring companies can often provide funds when banks cannot because of the three-way relationship of factoring services: you, your clients, and the factoring company. Where a bank will scrutinize your credit before providing a loan, we scrutinize your customer’s credit because they will ultimately pay on the invoice. So our underwriting criteria are different, and in many ways, more liberal than those of a bank.
Is Factoring Right for Your Business?
As a financial tool, factoring is most frequently used in times of rapid company growth or, as now, in times of economic stress. During rapid growth your demand for cash can outpace your cash-flow cycle. In times of economic stress credit is tight and customers take longer to pay.
These are realities of the business cycle. By understanding factoring you give yourself one more option for successfully navigating difficult financial waters.
Mr. Kocharhook is a Business Development Manager for Riviera Finance – a factoring company headquartered in Redondo Beach, CA, that has been providing professional “best practices” factoring services since 1969. He operates in Santa Clara, CA, and can be reached for additional information or consultation at dkocharhook@rivierafinance.com or at 800-336-2223.
