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Factoring Offers Financing Alternative for Small Businesses
by Sara Angeles, Business News Daily Staff Writer, March 25, 2014
Factoring lets small businesses raise capital by selling their accounts receivable
Need cash? Consider selling your accounts receivable. While approaching a lender is the most common way to raise capital, it’s not always the best or most viable solution for a small business. If a bank loan isn’t an option for your business, factoring can help.
Factoring is the purchase of a business’ accounts receivable. Large corporations have long used this method to increase cash and reduce the management of receivables, but it is now becoming a popular option for small businesses, as well, said Dave Kurrasch, vice president and general manager of Small Business Payments Company, which develops financial solutions for small businesses.
Factoring is an alternative to asset-based lending and provides businesses with capital when they need it. It is particularly appealing for businesses that need cash, but have limited sources of credit, he said. “Factoring is a fantastic method to convert inventory or work product into cash to pay vendors, payrolls, taxes or other obligations.” [15 Creative Ways to Finance Your Small Business]
Moreover, because factoring rids small businesses of receivables, it allows them to reduce or completely eliminate collections. “Managing the working capital conversion cycle is crucial for businesses that produce receivables with long collection terms,” Kurrasch added. “Factoring is a real option for shortening or eliminating collection times.”
How factoring works
Companies use factoring to raise cash, either to help them through a tough time or to expand their business. It involves no lending, but instead depends on a sale. Those who buy receivables are called factors. Most factors are independent companies, although banks own some of them. A factor buys invoices based on the credit of the customer. Brian Birnbaum, founder and director of Liquid Capital, said that factors generally advance somewhere between 75 to 80 percent of the receivable — meaning they will pay you 75 to 80 percent of the amount you are owed by your customer. Once your customer pays the bill to the factor, you receive the remainder of the amount owed.
“When the receivable is collected and the customer is notified to pay the factor directly, the customer receives the remainder of the reserve. If we deducted 20 percent, they would get that back, less fees,” Birnbaum said. Not only do factors advance against the receivable, but they also process the receivables. In essence, factoring means a small business owner outsources the company’s accounts receivable function.
Howard Hill, president of HRH Funding Solutions, thinks that factoring is as simple as it gets.
“It increases your credit score. There’s no loan and no money to pay back. It streamlines your receivables,” Hill said. Robert Zadek, attorney with Buchalter Nemer, focuses his practice on factoring. “There’s no downside, per se. Like any other product or service you buy in the world, you try to get the best service and best product for the lowest cost,” Zadek said. Factoring offers small businesses an alternative to taking out a bank loan, he said.
“If the bank would lend to you, you wouldn’t be in factoring. But there are many businesses that don’t go to a bank, even if they can. Getting money from a factor is so easy, as long as you’re honest with a factor. You don’t live in fear of losing your money. There are plenty of factors that can work with you. You’re not locked in like you are with a bank,” Zadek said.
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‘Factors’ to consider
Two of the most important things to look for in a factor are costs and the terms of the sale.
“When thinking about using factors, small business owners need to evaluate the total cost of outsourcing credit decisions and collections,” Kurrasch said. This is because factoring is typically more expensive than unsecured lines of credit, he added.
Furthermore, Kurrasch advised small businesses to pay attention to whether the receivables are sold “with recourse” or “without recourse.”
“If the receivables are sold ‘with recourse,’ the seller will be responsible for any uncollected receivables,” he explained. “If the receivables are sold ‘without recourse,’ then the seller is not liable for uncollected receivables.” Of course, factoring isn’t for every type of business.
“Generally, it’s used by a company that’s doing business to business. A great deal of factoring volume is done by those companies selling to retail trade,” Birnbaum said. Staffing, construction, transportation and medical companies also increasingly use factoring. The method also works best for businesses selling products or services and offering terms of 30 days or longer. Factoring eases their capital crunch and provides immediate financing, so they don’t have to keep money tied up in accounts receivable.
However, companies with a very low gross profit would not benefit from factoring.
“The only time that we tell clients that factoring doesn’t fit is if their profit margin is too low. Ideally, we like to see a client have 30 percent or more profit margin. If they’re down to 10 or 15 percent, we don’t want to impose anything that might hurt them more for profit,” Hill said.
Stepping stone to solvency
But for companies that can work as a team with their factors, the process can be a lifesaver. It can also act as a stepping stone towardgetting a small business loan from a bank.
Liquid Capital, for example, had a client that did rust-proofing and painting for large oil rigs and related products. “They came to us because they were losing money. The bank had called its loan, and they were close to insolvency,” Birnbaum said.
When the client used factoring, the practice removed the burden of collecting receivables. The client grew from $1.5 million to $10 million in sales over three years. “You have to wait for success and build up equity. Our client built up some reserve, and then they had the ratios that were required to graduate to a bank,” Birnbaum said.