Looking at Factoring in a Whole New Light

By Tracy Eden

In the post-financial-crisis world in which we now live, most business owners and entrepreneurs view commercial financing in a completely different light than they did before. With traditional bank loans getting harder to obtain, many owners have had to look “outside the box” for the capital they need to sustain and grow their firms.

In doing so, many have discovered (or sometimes rediscovered) the potential benefits of asset-based lending and factoring. Sarsha Adrian, a senior consultant with Graber Associates, a marketing and research firm that specializes in financial services, made this observation during a recent webinar.

“Factoring has re-emerged as a way for fast-moving, aggressive businesses to meet the critical need for working capital finance,” Adrian said. “There’s a change of opinion going on now—a mind shift about what factoring is. It’s almost like factoring is changing its name to ‘business-to-business payment financing.’”

No Longer a Last Resort: Meanwhile, a recent Wall Street Journal article discussed the rising popularity of asset-based lending, noting that this former “last-resort finance option” is gaining ground as traditional sources of capital dry up. “Asset-based lending has become a popular choice for companies that don’t have the credit ratings, track record or patience to pursue more traditional capital sources,” the article stated.

The volume of asset-based loans grew to nearly $600 billion in 2008, an increase of more than 8 percent, reports the Commercial Finance Association, and they expect that volume grew again in 2009, but this time by double digits. Compare this to syndicated lending, which decreased by 39 percent in 2009.

“There’s a huge difference now in the way business owners are looking at these financing options,” said Adrian. “They want some predictable way of understanding their cash flow. They are interested in an instrument that will finance their transactions, and they look at factoring as part of their payments.” Businesses may turn to factoring for a number of different reasons. In her webinar, Adrian noted a few of the most common:

•  Improve cash flow

• Build up cash reserves

• Avoid additional debt

• Don’t qualify or can’t wait for a traditional bank loan

Sixty percent of a typical firm’s cash is tied up in receivables, according to Adrian, and waiting for payment can put serious pressure on cash flow. “Selling receivables at a discount by factoring can help bring in cash quickly.” Another strategy used by some firms to speed up cash flow—offering so-called “2/10, net-30 discounts”—isn’t always effective, she adds, “because customers often take the two percent discount and still pay in 30 days.”

It’s Not a Loan: Factoring differs from traditional lending in that it is the actual purchase of accounts receivable by a bank or commercial finance company (usually referred to as a factor) from a business, not a loan of funds to the business. The receivables are purchased at a discount, typically 2-5 percent of the invoice amount, which constitutes the factor’s fee.

The factor advances a portion of the receivable (usually 80 percent) to the business immediately and the balance after it has made collection, less the discount. In most client-factor agreements, the business agrees to factor a minimum amount of money each month for the length of the contract period—usually 12-18 months. “In this way, factoring essentially becomes an unlimited line of credit,” said Adrian.

There are two primary types of factoring: recourse, in which the factor can demand payment from the client if its customers fail to pay receivables, and non-recourse, in which the factor cannot demand payment from the client even if its customers don’t pay. Because the factor is heavily dependent on the reliability of its clients’ customers, it will be especially concerned with their creditworthiness, carefully analyzing them and performing credit checks on potential new customers.

“What businesses like about factoring is that it’s not a loan,” said Adrian. “They’re not borrowing money so they’re not tying up collateral (other than the receivables that have been sold) or increasing the leverage ratio on their balance sheet. They’re getting immediate cash and they avoid doing all the paperwork associated with bank loans. Many see factoring as being much more convenient compared to bank financing, which is painfully slow.”

Another traditional type of asset-based lending involves the leveraging of accounts receivable, and in come cases inventory. Here, companies borrow money against the value of these assets, essentially using their receivables and inventory as collateral for the loan. The bank or finance company will advance funds to the business based on a calculation of the eligible outstanding receivables and inventory. Because these assets are so fluid, it requires a different level of monitoring than does traditional bank lending.

Overcoming Hesitations: One hesitation some companies have with factoring is unease about turning over their client lists to factors for collection. According to Adrian, this is much less of a concern today than it used to be. “A lot of businesses are using payment companies now in the normal course of doing business, and the customers’ names are known to them, so it’s not really an issue for most companies anymore.”

While some banks (mostly large ones) do asset-based lending, most is done by commercial finance and factoring companies. Your bank may refer you to an asset-based lender, or factor—if so, be sure to examine them thoroughly and perform careful due diligence. Professional experience and adequate capitalization are crucial, so ask how long they’ve been in business and how well capitalized they are.

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