Factoring has been around for thousands of years (seriously, it dates back to ancient Mesopotamia!). The practice has helped many people over the ages make money and succeed in business. According to many sources, factoring made the Medici family very rich during the Renaissance, and British bankers used it to fund American colonists in the fur, lumber, and cotton trades when the U.S. was just a gleam in the founding fathers’ eyes.
Factoring, put simply, is the selling of accounts receivables for a discounted amount. According to Inc.com, this alternative funding option “now accounts for more than $1 trillion a year in credit, triple what it was in the early 1990s.” With banks making it increasingly difficult for small businesses to obtain loans, factoring has experienced a resurgence in popularity in recent years. So why does the term “factoring” cause some business owners to cringe? Here, we debunk some of the misconceptions about the practice, and separate fact from fiction when it comes to factoring.
MYTH #1: Companies that use factoring are failing or struggling financially.
FACT: Major companies, and many successful small businesses, use factoring services to boost their available cash in a more immediate way. These services provide capital to growing businesses that is based on sales. Successful businesses with higher sales create more invoices, which can in turn be sold to the factor and provide the company immediate funds with which to continue growing. It’s a not-so-vicious cycle that lets businesses access their own money right away, instead of waiting for clients’ invoices to come due in 30, 60, or 90 days. With the tighter lending standards imposed by banks, factoring is becoming more and more common as a source of financing for a variety of businesses.
MYTH #2: Factoring is expensive
FACT: Factoring rates are competitive with other financing options. It is difficult to compare factoring rates with loan interest rates, because this is like comparing apples and oranges. Factoring rates are transactional; when the factor buys a company’s invoices at a discounted rate, this discount is similar to bank fees that are charged to advance cash on credit card sales.
In reality, factoring isn’t the best option for every business, or every situation. The bottom line is to know whether factoring your accounts receivable will bring in more money than it costs. For example, if your business has been turned down for bank loans or credit requests, factoring may be your only viable option. In a choice between no funding or factoring, the latter should probably win out. Also, in many cases, the fees and discounts associated with factoring are less than the interest and other fees that go along with traditional loans.
There are other ways that factoring can improve cash flow, too. Clients will often pay factored invoices before non-factored, because it is more likely to affect their credit rating if they don’t. When you have access to your funds from factoring, you can get better rates from your own suppliers, since you don’t have to buy on credit. Not to mention having the funds to increase marketing and promotion of your company, which will generate sales. If these benefits outweigh the costs of using a factor, then this type of financing might be right for you.
MYTH #3: You will make your customers angry, or worse yet, lose their business.
To be honest, some of your customers might not like the fact that you are using a factoring company, but these are the very clients whose payments you find yourself waiting for each month! When dealing with a factoring company that is larger than your own business, not paying on time is more likely to affect your clients’ credit, and they might not like that. But for you, it means getting paid on time by someone who might have put you off another 30 days or so. Most customers should be comfortable with your use of a factor, because it means you will have the money you need to succeed and meet their needs. However, factoring companies are aware of the potential discomfort, and many deal with customers as if the communication were from the company directly.
Factoring companies succeed when you succeed. To that end, they employ professionals who are well practiced in building relationships and goodwill with clients, while at the same time confirming prompt payments.
MYTH #4: Factoring is only for large (or small) businesses.
FACT: Any company that offers goods or services to another organization on credit can access their funds through a factoring service. If you have a reputable, quality customer base, any factor should be willing to purchase your invoices and provide you with the funds you need. Factoring services will often run credit checks to determine if your customers are likely to pay (another benefit for you!) and offer funding based on their findings.
In previous years, factoring was used almost exclusively by large businesses, but today, small businesses utilize factoring more often than their more sizeable counterparts. Accounts receivable factoring is an excellent alternative for small businesses that don’t yet qualify for bank loans, but still need capital to grow. Any business that extends credit to its customers can benefit from factoring their invoices. There are even factoring services that buy small invoices, advancing just a few thousand dollars to qualified businesses.
MYTH #5: Factoring cuts a high percentage off of your business’ profits.
FACT: Reputable factoring companies typically take 0.5% or less of your profits. Most factors will grant you 80-90% of your invoices right off the bat, and will pay out the remainder once your customer pays the debt. You will likely pay some type of service fee for the daily management of the factoring company, but you receive the benefit of having someone else worrying about collecting your accounts receivable. These service fees are based on the expected turnover of your invoices, and typically are less than 0.5 % of the turnover.
Factoring can cut into your profits, as the seemingly low 2-3% discount on a 30-day invoice becomes a high annual rate of 25-36%. However, the benefits often outweigh the costs, as you get instant access to needed capital; capital that can be immediately put back into the business and create more profit. The service also fills a need when banks won’t lend to a business, and provides relief from the aggravation of collecting from clients.
With banks constantly tightening their purse strings, factoring is quickly becoming one of the most popular forms of alternative finance for businesses of all sizes. Many of the negative connotations associated with this funding source are unfounded or just plain false. If your business is in need of quick capital and the banks can’t help, factoring might be the perfect solution to your cash flow problems.