Factoring Receivables is an Alternative Form of Business Financing

With the ongoing consolidation of the banking industry, financing options previously available to small businesses are becoming fewer. The few remaining independent banks and large banking chains have credit standards that are often to restrictive for small businesses.

As a result of an increased amount of bad loans, and regulatory pressure to avoid high-risk loans, fewer banks exist today that are able and willing to provide accounts receivable financing to small and medium size businesses. The commercial bank’s inability to provide this type of loan has created a need for an alternative form of finance know as “factoring”. Invoice factoring is one of the oldest forms of working capital financing that, until recently, was unavailable for small to mid size businesses.

A factoring company differs from a banker in many respects. A banker extends credit based on the financial condition and cash flow of the borrower. The borrower is expected to make monthly or quarterly payments to the bank on good times and bad. Therefore, the borrower must meet rigorous financial requirements and have a long, successful track record before obtaining a bank loan.

Factoring companies do not require the client to have a strong balance sheet or demonstrate years of profitability. Factoring companies in general are more interested in the credit worthiness and financial strength of the client’s customers. If the client’s customers are strong, the factor is usually able to provide financing by factoring (purchasing) the client’s accounts receivable.

A factor recognizes an invoice as an immediate asset for purchasing so long as the service (or products delivered) has been provided and accepted by the customer. The invoice is verified and then the advance is funded, typically 75% to 95% of the invoice value. This is usually completed the same day that the invoices are received.
The balance of the advance is called the "Reserve". The reserve is held back until the customer pays the invoice in full and the invoice transaction settles. The fee is deducted from the reserve and the balance is available for withdraw.

For example, your company factors an invoice for $1,000 and you get a 90% ($900.00) advance, 10% ($100.00) is held in reserve. When the invoice is paid the transaction settles with a 3% ($30.00) fee and the balance 7% ($70.00) is placed in your withdraw account. In this example the total fee was $30.00 for factoring a $1000.00 invoice.
Factors often work in conjunction with banks. Occasionally a bank customer may have a sudden need for working capital that exceeds the bank line of credit. The factor, in such instance may negotiate an agreement with the banker which will allow the factor to finance a specific invoice account while the bank holds the rest of its borrower’s accounts receivables collateral.

In summary, factoring receivables is an alternative form of finance widely used by small businesses. It is a very flexible financing mechanism which can assists all kinds of businesses in meeting payroll, taking trade discounts with suppliers, or simply increasing liquidity to sustain growth.