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Working with Factoring Companies as an Alternative to Bank Credit

Published 9/22/2012

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Business owners have several options when it comes to obtaining financing for their companies. There is the possibility of utilizing traditional methods, such as securing investors or establishing some sort of business credit line with a bank or other financial institution. There is also the option of working with a factoring company and making use of the company's accounts receivables to finance the continued operation. There are compelling reasons why using this approach may be the right fit for your business.

What is Factoring?

Factoring is a financial strategy that allows businesses to obtain money from their receivables before customers actually remit payments. The factoring partner will assess the invoices that are associated with the most recently completed billing period and in effect offer to buy those invoices at face value. As part of the deal, the buyer will advance the debtor a specified percentage of that face amount of the invoice, usually between eighty and ninety percent. In return, payments are remitted to an address supplied by the buyer and credited to the debtor's account.

Once the total amount of the advance payment has been settled, the buyer will allow the debtor access to the remaining collected funds. In exchange for providing this financial solution, the buyer will retain a percentage of the total value of those receivables called the discount fee, usually somewhere between one and five percent.

Many company owners like this arrangement, since it means there is no need to qualify for credit through banks or deal with a lengthy loan application process. Once the account is established, it is possible to factor each billing period and be able to use the proceeds to cover company expenses and even fund special expansion projects.

What Type of Companies Use Factoring?

The use of factoring as a financial strategy can apply to many different types of businesses. Factoring Companies usually establish specific criteria that must be met in order to enter into this type of financial arrangement. While larger corporations in various industries are highly likely to qualify, it is not unusual for partners to also work with smaller businesses that are able to demonstrate a consistent cash flow in the form of payment remittances from customers.

Most factoring companies will look closely at the applicant's current circumstances. This includes an analysis of the related industry and the projected impact that the movement of the economy will have on that industry. In addition, the partner will consider the length of time the applicant has been in business and the level of expertise and experience that the management team brings to the table. In other words, the partner will want to make sure that the applicant does not present a risk that outweighs the benefits of entering into a financial arrangement.

Factoring Versus a Business Credit Line

In times past, business owners would often talk with different banks and choose one as the home for a business line of credit. This approach can work very well, assuming that any balance charged to that credit line is paid in full before the closing date. In the event that a balance is allowed to roll over from one billing period to the next, the bank will apply interest to that outstanding balance. Depending on the credit rating of the company, the interest rate could be significant. Carrying a balance from month to month could consume an impressive amount of revenue over the course of a year.

By contrast, interest is not a factor when businesses choose to work with factoring companies. Since the financing is an advance rather than a loan in the strictest sense, the company is paying a fee for the advance. There is no charge to roll over from one month to the next. Essentially, you and your company get to start fresh every billing period.

Factoring Versus Receiving a Bank Loan

Another financing strategy is to secure some type of bank loan. With this approach, the company owner is getting funds in advance that can be used for everything from meeting payroll to funding a new marketing scheme. At the same time, the owner is also taking on another financial obligation. This means that the company will have to arrange its budget so that installment payments can be made on the loan balance until it is paid in full.

Like the line of credit, a bank loan involves the application of interest to the outstanding balance. Depending on the amount of the loan, the fees and charges that are bundled in with the original loan request and the way that the interest rate is applied to that balance, the company will often pay a considerable amount back to the bank.

With factoring, there is no need to rearrange the operating budget to include another debt obligation. The funds obtained from the factoring partner are based on the value of the purchased invoices. There is no opportunity to incur late charges or to default on the loan. Instead, the funds are made available for immediate use and are not subject to interest in any form. As long as your customers submit payments according to terms, the arrangement will benefit your company and the factoring partner.

What do I Look for in Factoring Companies?

In order for the relationship to be mutually advantageous, it is your responsibility to make sure that the factoring partner is a good fit for your needs. Early on, you want to compare the terms and conditions that will govern how the invoices are factored, the percentage of the advance that is provided on the front end, and the amount you ultimately pay for the service. You also want to understand the reporting processes that are in place. This includes access to an interface that helps you track the receipt of payments from your customers and the ability to see how much money is available for transfer to your company bank accounts.

You also want to make sure that the collection policies and procedures of the factoring partner are in harmony with the processes that your company normally employs. Take the time to review those processes with the partner before entering into any type of financial arrangement. You want to see the templates used for collection letters and also the basic script that is used when making collection calls. The goal is to make sure that the processes are balanced and fair, and not likely to cause the loss of a long time client who happened to be a few days late in paying an invoice.

Once you and the factoring partner are satisfied that an arrangement between the two entities is possible, you can proceed with formalizing the relationship. Keep in mind that if your company should choose to terminate the agreement, it is necessary to work with the factoring partner to end the factoring process in a manner that is in line with the terms found in the contractual agreement. This will often include covering the balance of any remaining invoices that your customers have not paid, allowing your company to essentially buy back those invoices. Once the arrangement is terminated to the satisfaction of both parties, your company will once again assume control of issuing its own receivables and collecting the balances due on those invoices.

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