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 difference 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, which mean asset-based lenders will typically monitor the collateral much more closely than a bank will.
Accounts Receivable Factoring
Accounts receivable factoring works a little differently than asset-based lending because the financing firm (factor) 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.
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 flow without incurring more debt. This allows 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.
How is Factoring Different?
Not many business owners have ever heard of factoring, even though it’s a legitimate and long-standing finance tool. Factoring companies gained more recognition and loyalty during the recession when banks put a stop on the free-for-all lending practices of the past decade. Many small and medium-sized businesses rode out the recession, even managed to grow, thanks to factoring. Now that traditional credit financing is beginning its come-back, the savvy business owner should consider all options, including factoring.
Here’s a quick look at how traditional bank loans compare to invoice factoring.
Time in business: Bank loans typically require a minimum of 3-5 years in business while factoring is commonly used by both start-ups and established companies.
Required documentation: Applying for a bank loan requires a business plan, three years of financial history, three years of business tax returns and personal tax returns along with current personal financial statements. A factoring company will want to see your balance sheet and P/L report, last year’s tax return and a current A/R aging report.
Ratios examined: A bank will review your liquidity, leverage, inventory, turnover, receivables turnover, gross profit margins and return on sales. A factoring company typically does not review ratios.
Credit ratings: Banks won’t give many loans to businesses with less than a stellar credit ratings. Factoring companies look at the credit rating of your customers.
Use of funds: Banks can require that the funds they provide are allocated for certain uses (inventory, equipment, etc.) Cash from a factoring company can be used however is best for your business.
Approval time: Approval for a bank loan can take months while getting approved for factoring can take a few days.
Repayment of funds: Banks require a monthly payment for a set term to repay the borrowed funds. Factoring is a process that does not incur any debt for your business, which means no payments — ever.
Universal Funding is a full-service factor and offers a wide range of services that can be tailored to meet your needs. Our goal is to keep companies moving forward by relieving the worry associated with sporadic cash flow. Give us a call today at 1-855-637-2352 or complete a rate form and a factoring specialist will get in touch with you right away to see if factoring can assist you with your cash flow needs.