HOW A FACTOR COMPANY CAN BE A USEFUL SOURCE OF FUNDS FOR SMALL BUSINESS OWNERS
Factoring is a form of financing in which a business sells its receivables to a third party or “factor company” at a discounted price. Under this arrangement, the factor agrees to provide financing and other services to the selling business in return for interest and fees on the money that they advanced against receivables invoices. Business in need of cash can thus secure up to 80 percent of the receivables’ face value (a high percentage can sometimes be secured, but in most instances 20 percent is held in reserve until the account balances are paid off).
Factoring is a favorite capital raising choice established for small business owners. A factor company can be a useful source of funds if you are already in business and have made sales to customers. Factor companies purchase your accounts receivable at a discount, thereby freeing cash for you sooner than if you had to collect the money yourself. They can either provide recourse financing, in which a small business is ultimately responsible if its customers do not pay, or nonrecourse financing, in which the factor company bears that risk. Factor companies can be a useful source of funds for existing businesses, but they are not a realistic “seed money” option for startups because such businesses do not yet have a base of customers – or accounts receivables – to offer.
Small business owners should be aware that factoring is different in several fundamental respects from bank financing. For one thing, it is more expensive. Costs usually represent 2 percent to 10 percent of sales. Fees deducted from the balances paid to you (the small business owner) include a finance charge, which may run 1percent to 5 percent above the current prime rate, and a service charge that is often a function of the daily balance outstanding, increasing as the balances age.
Arrangements for fees vary widely, depending on the credit quality of your customer account balances and the range of services that you are purchasing from the factor. In addition, small business owners should recognize that utilizing a factor company is an all – or- nothing proposition. Factors demand 100 percent of a client’s receivables. They will not limit their efforts to those receivables considered marginal or high risk.
Selecting a Factor
Selecting a factor is much the same as selecting any other service provider. Find the best service provider. There are several considerations that should be weighed by the small business owner in making fee arrangements with a factor:
Small business enterprises that elect to go with a recourse factor (in which they bear final responsibility for collecting monies owed) over nonrecourse factors (where the factor company bears that responsibility) will find that they may gain lower fees and more money from the factor in return for increasing their risk.
The larger the number of customers, the more cost advantages the factor can provide. Automation gives factors significant economies of scale in this area. Creditworthiness of customers is a fundamental element in factor pricing. Factors will not purchase substandard customer balances.
Size and Age of the Average Invoice
Small receivables that have been on the books for a while will result in less advantageous factoring arrangements for small business owners than with large current receivables.
Some factors tend to work with larger businesses, while others concentrate their efforts to smaller enterprises. Large factor companies tend to focus their attentions on companies that have at least $10 million in annual sales, while smaller factor companies – sometimes known as “re factors” – may provide services to companies with annual sales of less than $300,000.
Most factors that reach agreements with small businesses will have a fairly solid understanding of the industry and competitive environment in which those businesses operate. Such factor companies can provide help to small businesses in determining who they should (and should not) extend credit to. In addition, factor companies can be helpful in settling upon credit limits for both new and existing customers. “Assess the factor’s understanding of your industry to get the most for your money,” counseled an industry analyst.
Most businesses in today’s environment have implemented automated processes to calculate and monitor accounts receivable and cash applications of cash received. Small business owners should make sure that their systems are compatible with those of the factor before agreeing to a factoring arrangement.
As indicated above, this can be a tricky area for the small business owner. Handing over collection duties to a factor company is expensive, and over-aggressive collection efforts on their part can damage a small business’s relations with legitimate clients. Factor companies also often have better luck in collecting monies owed than do small business enterprises, which have limited resources that they can allocate to collections process.
Business owners should recognize, however, that the factor is only interested in business transactions in which their client is owed money. Factors will not be responsible for non-payment that is attributed to other issues, such as vendor disputes or defective merchandize.
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