by Andrea Becca
“Get the fact, or the fact will get you.” This Thomas Fuller’s motto is true in business. That’s why many small business may need some extra funds at the wrong time. Factoring can be a possibile answer to their needs. What is factoring? What are pros and cons of this financial instrument? Factoring is one of the oldest forms of commercial finance. The term factor comes from the Latin verb “facio”, which means “he who does things.†Some scholars trace factoring origin to the Roman Empire. Others go further back to the Hammurabi, four thousand years ago.
What is factoring today? Factoring (also known as Accounts Receivable Financing) is the practice of selling your accounts receivable (invoices) at a discount to another company. In other words, you get the cash from the company that you sold your accounts receivable. At that point, they become responsible for collecting on the invoices.
There are usually three parties involved in this operation: 1) the seller of the product or service who originates the invoice; 2) the debtor is the recipient of the invoice for services rendered who promises to pay the balance within the agreed payment terms; 3)the factor.
Why should I use factoring? Small businesses most of the times have no choice: slowing their growth or using external funds beyond the banks. In choosing to use external funds beyond the banks, the rapidly growing firms choice is between seeking angel investors (i.e., equity) or the lower cost of selling invoices to finance their growth. The latter is also easier to access and can be obtained in a matter of a week or two, versus the six months plus that securing funds from angel investment typically occurs. Factoring is also used as bridge financing while the firm pursues angel investors and in conjunction with angel financing to provide a lower average cost of funds than would equity financing alone. Firms can also combine the three types of financing, angel/venture, factoring and bank line of credit to further reduce their total cost of funds. In this they can emulate larger firms.
What is the main difference between factoring and bank loans? Factors make funds available, even when banks would not do so. That’s for a simple reason: factors focus first on the credit worthiness of the debtor, the party who is obligated to pay the invoices for goods or services delivered by the seller. On the other side, the fundamental emphasis in a bank lending relationship is on the creditworthiness of the small firm, not that of its customers. While bank lending offers funds to small companies at a lower cost than factoring, the key terms and conditions under which the small firm must operate differ significantly. Moreover, bank relationships provide a more limited availability of funds and none of the bundle of services that factors offer.
How can accounts receivable funding help my business? By providing an immediate source of cash flow for your company. You can use this cash to provide working capital, meet payroll, pay taxes, inventory, increase advertising, purchase equipment, improve your credit rating, and more.
What are the potential disadvantages with accounts receivable funding?
First of all: costs. Costs can vary depending on the nature of the debt/invoices. Secondly, the fact that your clients have to deal with the factoring companies. Besides, there may be other financial implications because your ability to borrow money may be reduced. Your accountant should be able to examine your individual circumstances and advise whether there may be any additional implications for you.
About the Author
Andrea Becca is a professional journalist and a translator from English, French into Italian, specialised in credit and banking topics.