Tame the Ebb and Flow

By SmallBusinessComputing Staff | Posted February 21, 2001
by Mark E. Battersby

Looking for quick cash? You need to pay bills and buy supplies, but can't make a move until customers pay what they owe you. Rapidly growing start-ups, manufacturing firms, and service companies without track records, collateral, or personal resources are often unable to obtain the financing they need to weather the drawn-out cash-flow cycles common to their industries. Many businesses that find themselves in these situations employ the services of a factoring company to solve the cash-flow dilemma.

Factoring is the process of selling all or a portion of a business' accounts receivable at a discounted rate, in exchange for immediate or near-immediate cash. For instance, toy and garment manufacturers often employ the services of a factor. A toy maker might send a completed order to a department store, but the store has 30 to 60 days to pay the invoice. In the meantime, the toy company could receive a very large order from another group, and need immediate cash to purchase supplies. In order to fulfill this order, the toy maker enlists a factor to purchase the department store's account. The factor then provides the toy maker with cash, which it uses to buy supplies.

Like many other financial services -- such as bill payment, banking, and stock trading -- factoring has moved on line. Now it's much easier to find, compare, and apply for factoring services. However, unlike banking services, factors are not regulated closely at either the federal or state level. Therefore, businesses that choose to use factoring services need to do their homework. Before you jump on line in search of a helping hand, you'll need to learn some basics about the industry.

Who are the Factors?
For an industry with a national gross volume of between $85 and $100 billion, factoring remains a little known (and little understood) strategy for increasing a business' working capital. Factors measure the viability of a business by looking at what it does, how well it does it, and the financial strength of its customers -- not by financial ratios, equity, profitability, or years in business. If they determine an account to be viable, they purchase the invoice and advance the cash to the business.

Using a factoring service can best be compared to accepting credit cards for payments. When a store accepts a credit card purchase, it essentially sells the amount due from the customer to the credit card company, which charges the store a small fee. The credit card company immediately wires payment for the purchase to the store and assumes the responsibility of collection. A factor acts as a commercial credit card service that gives a business the ability to sell its receivables in return for immediate funds, albeit for a much higher fee than those imposed by credit card companies.

"Factors buy the receivables on a monthly basis, or carry them until they are paid," says Herbert M. Ausderau, counselor with the U.S. Small Business Administration's Service Core of Retired Executives. "The fees can be quite huge -- from two to seven percent a month. The fee is only paid as long as the receivable is outstanding and typically such receivables are paid within 30 to 60 days. Nonetheless, it's an expensive proposition."

How expensive? Premier Bank in Denver, Colo., offers factoring services to local businesses. According to Jeffrey Lee, Premier's president, the bank will purchase a company's invoices, typically paying the company about 80 cents on the dollar immediately while holding 20 cents in reserve. After the bank collects its money from the invoices, it gives the client company the remaining 15 cents to 18 cents on the dollar and pockets the 2-to-5-cent difference.

Say When
Sure, factors can produce quick cash when times are tight, but check out all the options before you turn to one. Ausderau cautions that factors are lenders of last resort. "First, go to your bank, your friends, or your relatives," he says. "If that fails, go to a factor."

Factors are best employed for short-term cash-flow problems. If a company doubles its sales, for example, it will need to expand its inventory. If enough money doesn't come in to cover the inventory costs, a factor might be a good place to turn to acquire the cash necessary to keep production rolling. "It is strictly a short-term means for a business to get cash when it can't find money somewhere else," Ausderau says.

But don't go to a factoring service to cover past-due accounts. As a rule, factors will refuse to accept late accounts, in part because it increases their risks. And chances are if you had trouble receiving payment from a customer, a factor will have the same trouble -- and you will be charged for the length of time the account remains unpaid. "If the account's bad to begin with, write it off or bury it, but don't try to factor it out," Ausderau suggests.

When deciding if factoring is right for your business, consider whether there are clear advantages of having immediate access to the cash tied up in your accounts receivable. Ausderau advises companies to examine the terms of a factor agreement closely. "People will initially hear seven percent, and think that's not that bad," he says. "They think, 'That's only $7,000 on $100,000.'" Find out in detail how fees will be applied. "I wouldn't want to find out they're charging seven percent per month, and find myself paying 14 percent if it takes more than 31 days for an account to be paid off," Ausderau says.

Financing and Services
If you choose to use a factor, remember that it will become an integral part of your company. With this in mind, it is important to evaluate a factor as critically as they evaluate you.

Factors offer a number of services. First and foremost, they provide a quick source of cash. Once a business has signed up with a factor, it can expect a turnaround time of as little as 24 hours between the submission of the account receivable until payment is wired or transferred by the factor to the business. The processing time for some factors can be as long as five to seven days with three to five days required to issue financial-commitment letters.

A factor can also supplement the efforts of a business' collection efforts by being a third-party accounts receivable management firm. Factors can verify shipment arrivals, provide detailed aging and collection reports, make calls to customers, and process lockbox collections. In addition, a good factor will provide supplier-payment guarantees, pre-award financial-commitment letters, and credit reviews on current and potential customers.

Many factors will allow a business to handle its own collections in order to preserve its relationship with the customer. Others, particularly banks, use a lockbox system where all payments are sent to a box that can only be opened by the factoring bank.

Money on Line
Of course, if your company needs a factoring service, you'll want to find one quickly. Now that many factors are on the Web, businesses will be able to find information on factoring services faster.

The Web makes it possible for businesses to quickly compare fees and terms. In addition to individual sites, businesses can cull information from commercial credit portals. Some commercial credit sites provide online application services to match businesses with appropriate factors.

Good cash-flow management is vital for businesses of all sizes, and funds provided through factoring can create a solid, dependable cash flow in a pinch. But whether you look for a factor on line or off, choose carefully.

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