What is factoring and how can it help businesses?
Invoice factoring, also known as accounts receivable financing, is a form of asset-based financing.
Everyone is familiar with bank loans, which are a primary source of business financing. Banks and other providers of traditional funding options analyze a company’s income statement, balance sheet, etc., to establish the value and creditworthiness of the company. The amount of credit and the terms offered by banks will depend heavily on the information derived from the financials such as the ratios of profitability, debt (leverage), and liquidity. The better a company looks on paper the more likely it will be approved for the desired amount of credit and under favorable terms.
Instead of focusing on the potential “success” of a company- which a bank defines as the ability to repay the loan plus interest- asset based lenders are interested in the value that already exists within the company.
The easiest example of an asset based loan occurs when a company puts existing inventory up as collateral. The process here is simple:
- A company has inventory but no cash.
- An asset-based lender will advance a sum of money based on the liquidity value of the inventory (collateral).
- If the loan falls into default the lender takes control of the stated collateral.
Of course banks like this idea of collateral to secure the loans they make as well. The main differences in this case is that banks still make their decision based primarily on financial statements and asset based lenders look more at the liquidity of assets meaning asset based lenders will typically monitor the collateral much more closely than a bank will.
Accounts Receivable Factoring works a little differently than the example above, because the financing firm essentially buys a company’s invoices.
Invoice factors can advance a percentage- say 80 percent- of outstanding accounts receivable to the company in 1 or 2 days. The factor then becomes entitled to collect the accounts from the third party debtors.
The 20 percent of the invoices not paid to the invoice seller is referred to as the “reserve,” which factors hold in order to limit potential losses from bad debt, etc. When an invoice is paid in full the factor’s fees are subtracted from the amount held in reserve and the remainder is returned to the client. Of course the fees will vary based on a number of variables, but Universal Funding offers rates that begin as low as .55 percent. (If you are currently factoring and paying over 2 percent, contact us!)
Invoice factoring can be more effective than short term business loans in raising immediate working capital especially for small and/or riskier businesses. Companies that factor invoices increase their cash flows without incurring more debt. This allows such companies to pay their liabilities in a timely manner, increase production, expand operations, and become more profitable. Factoring is certainly a growing sector of the financial industry and can be advantageous for many businesses in the current economy.