Factoring Company Info: Let’s face it, nobody likes waiting for their money. Small and medium-sized businesses routinely send invoices to customers for services rendered. But when they don’t get paid immediately, they become classified as accounts receivable. If enough assets become receivables, it could evolve into a liquidity crunch for the business.
The consequences of having too much capital tied up are severe. The business could miss the payroll for its employees, pass on a key opportunity or even default on a loan. A lack of liquidity can also lower a company’s credit rating, leading to higher borrowing costs. None of these outcomes is acceptable so many businesses turn to third-party financiers known as factoring companies.
What is a Factoring Company?
A factoring company provides liquidity solutions (advances) to business customers awaiting payments for a price.
Here’s how it works. A business accrues an excessive amount of receivables which is hampering its ability to operate effectively. They contact a factoring company who is willing to provide them with interim financing.
With a financing agreement, the factoring company agrees to purchase their client’s accounts receivable and advance money based on their dollar value. Receivables are typically advanced at 80%.1 Different variables go into this determination, mostly the credit rating of the specific customer(s) that owes the receivable. The factoring company will apply due diligence on their creditworthiness before issuing a quote. The delinquency of the invoices (30, 60 or 90 days past due) is also a major factor.
If it is non-recourse factoring, the factoring company will incur the credit risk of the accounts receivables being paid. If the factoring transaction is recourse then the risk remains with the business and does not transfer over to the factoring company.2 The quote will include the factoring company’s fee of a few percent. We’ll assume 2%.
A Factoring Example
If the factoring company determines the receivables are likely collectible, it may advance the business 90% of their face value. When the receivables eventually get paid, they are paid directly to the factoring company, not the business where they were originally owed. The factoring company then returns the remaining deficit (10%) to the business less the agreed upon fees (2%). In this example, the cash flow was significantly increased for the business and they eventually recouped 98% of the value of their receivables. The company was also able to focus on its core business during the time period, not chasing down money.
This can be a highly lucrative business. The factoring company hopes the business will become a repeat factoring customer which would mean a recurring revenue stream. A 2% fee might not seem like much but if the receivables were paid back within the first 30 days, that’s 2% for one month or 24% annualized ‘return’ (credit card interest rates) if the same factoring transaction occurred every month. In addition, the factoring company may tack on additional fees including shipping, collateral and money transfer fees.3 The rates of return for some of these factoring companies are similar to private equity and some are even owned by PE firms.
This can be a highly lucrative business. The factoring company hopes the business will become a repeat factoring customer which would mean a recurring revenue stream. A 2% fee might not seem like much but if the receivables were paid back within the first 30 days, that’s 2% for one month or 24% annualized ‘return’ (credit card interest rates) if the same factoring transaction occurred every month.
Some factoring companies provide other financing options including asset-backed lending (ABL). Factoring technically involves the sale of receivables to the third-party factoring company.4 Financing typically refers to a loan that is collateralized by various tangible assets such as machinery and equipment. When these assets utilized, it’s referred to as equipment financing.
Factoring vs Borrowing
Factoring is often preferred to a bank loan, especially for start-up companies. This is because, with their short operating history, they often can’t get traditional financing (or lending at reasonable interest rates). Also, factoring incurs no debt. This can be important for companies with outstanding debt issues who have covenants restricting debt levels. Loans have a pre-determined principal amount, where the financing capacity from factoring can grow along with the assets (such as accounts receivable).5 Finally, anyone knows that getting a loan is a major hassle. Collecting documents, filling out forms and waiting for credit checks eat up time, often months.
Factoring clients can get on-boarded in under a week usually and subsequent factoring transactions can be done in less than 24 hours. Finally, the credit checks in a factoring transaction are for the customer owing the receivables, not the business. In short, factoring provides more flexible financing options than traditional bank loans or lines of credit.
The trucking, manufacturing and oil and gas industries rely heavily on factoring and asset-based lending. Trucking companies especially because of the time needed to transport the goods, which often are often paid upon receipt. Of course, there are plenty of costs for the trucking to perform the delivery that are necessary up front.
Specialty finance companies with unique niches like factoring, litigation finance, and annuity purchasing are growing in popularity along with the need for alternative financing. They ebb and flow with overall credit conditions but can still be lucrative under almost any economic condition.