Unfortunately it’s still a best kept secret of business financing; invoice factoring. With all the financing available the concept of factoring accounts receivables for operational cash flow is still not widely considered. The transaction is very easy to understand, simple to set up, flexible to use, and becomes critical to the many companies who stumble onto it.

While there are so many types of financing available; bank term loans, revolving lines of credit, loans with warrants, asset based loans, direct public offerings, mezzanine financing, private placements, all sorts of equity participation, a company looking for outside capital has to be aware of, and have some basic understanding of the benefits and drawbacks of all forms of financing before choosing one method.

Be advised, factoring is a tool that is perfect only for certain situations. Capital intensive requirements like labor costs and product purchases are ideal for growing companies seeking to use the factoring model.

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Many business owners wonder why the cost of invoice factoring is higher than a typical conventional line of credit. Usually the first thing the uninitiated will do is calculate the monthly discount fee multiplied by 12. Unfortunately this is a bad assumption. When utilizing accounts receivable financing the borrower does not get funded for a year, they get funded for a month. This short term access to financing is due to the financial condition of the borrowers business. In other words, it is not strong enough to secure annualized funding. Factoring companies take a larger risk but keep the borrower on a shorter leash.

The primary reason that a factoring company has to charge more for its financing is the heavy transaction load required to service the debt. Each invoice must get the account debtor’s (customer) credit checked, then verified as due and owing, then tracked for payment. It requires more staff, more time and resources than a simple line of credit which is largely overseen by a bank’s computer.

So even though factoring may seem to cost more in the short term, it is still a very handy tool for growing a business

The economic benefits of factoring your invoices are based on improving your cash flow cycle. Using AR factoring helps you increase the number of times your working capital moves through the business. The process of making a sale, purchasing product, and getting paid creates a cycle of cash flow.

Hypothetically each sale you make, creates a profit. On average, a business may cycle its cash through seven or eight times annually. But by utilizing the benefits of accounts receivable financing that average can be increased. Getting paid faster on invoices means you have cash on hand to buy more, to sell more. Thus you increase your bottom line by earning profit more times a year. Invoice factoring is one of many ways to make your cash flow cycle work more optimally for your overall bottom line growth.

In order to use accounts receivable factoring for a growth business, the work being performed must be completed and accepted. Submitting an invoice to be funded prior to the work being done is called “pre-billing.” A good example of this would be with products being shipped in stages. You cannot invoice for the entire production sold until each batch of product reaches its destination.

The concept of pre-billing and why a factoring company will not fund those invoices is the potential for the customer to refuse to pay the invoice and win in court on a collection action. Without proof that the service has been fully rendered or the purchase order fully received, the court will be reluctant to side with the collector. A factoring company has to know that their collection rights are solid in order to mitigate the risk involved in making an advance on invoices.

Due to the verification process of contacting the customer to ascertain the invoice is live, the collection issue is rarely required. It just means a pre-billed invoice will not be funded until the work is completed.

Some companies who utilize invoice factoring only want to use it as needed. This means they want the choice of picking and choosing which invoices to finance. There are many factoring companies that set up the account to factor every invoice. They want complete control over the entire accounts receivable base. We DO NOT require this; you are free to choose which invoices you want to submit for funding.

There is a logistical issue though when deciding which customer accounts to finance. Once you determine that a particular customer account is suitable for receivable factoring all payments made by that customer will have to come directly to us for processing. The reason for this is, the accounts payable department of your customer will not be able to properly keep track of which invoices are paid to each ‘remit to’ address. So to simplify the interaction, once you have chosen a particular customer, all payment instructions are made to go directly to us. As a payment is received and we see that it is an ‘unfactored’ invoice – one you did not submit for funding, we turn 100% of that payment back to you without deducting any fees.

So the choice is yours, but the process is ours.

It’s important for business owners to have regularly updated bookkeeping. Beyond the necessity to have a proper roadmap of your company’s condition, knowing where you are at a given time helps to set the ongoing strategy to run the business. But for this particular post, the importance of financial reporting is absolutely necessary for setting up a receivables factoring relationship.

Even though a factoring company will base its decision to fund on the creditworthiness of the account debtor (your customer,) we still would like to see current financials to get some context. This should be easily attainable by accessing up to date bookkeeping.

Normally we would ask for a current Balance Sheet, Profit & Loss Statement and Accounts Receivable Aging report. The aging report is the most important to gauge who the customers are and how active their payments have been over time. The Balance Sheet will highlight your outstanding long term liabilities that might encumber your existing assets.

There are many reasons to have updated bookkeeping, so have the commitment and resources set aside to deal with this critical activity.

It is significant to realize you may encounter a contract period commitment in a Factoring Purchase and Sale agreement. Some factoring companies require this condition in order to lock in a low rate that they are offering you for making advances on your invoices. This guarantees that a minimum amount of fees will be generated through the period of the factoring relationship. The same is true for minimum monthly usage, which commits you to finance a required amount of invoices every month or pay a penalty.

Now under the heading of “No One Reads the Instruction Manual Anymore,” be advised that if you sign a contract where you are committing to fund over a period of time, there will be a penalty for leaving early. Look into it before you sign, it may become a costly mistake. Also make sure to know about automatic contract renewals. Whereby if you do not formally notify the factoring company that you plan to leave at the end of the commitment period you will be automatically committed for another period. This is part of the commercial financing landscape and not meant to be underhanded. Technically the lender is locking in their yield or profit on the relationship at the start. But it’s your obligation to know what you are signing in a contract. If you are not sure, ask questions.

Here at Creative Capital Associates we do not require contract period commitments or monthly minimum purchases.

Often setting up a new factoring relationship for your accounts receivable financing may be a very delicate series of negotiations, diplomacy, and tact. There could be many parties involved, including old past liens that are still in filed, previous or current lenders who are not privy to your transition plans, partners who do not agree to terms, vendors whose processes can’t be disturbed, tax problems that have to be tended to before any financing considerations can be solidified.

Knowing how to keep all these balls in the air without letting any hit the ground is a skill set that is equally important to all other considerations when making a decision to work with a particular factoring company. Understanding all the elements that go into a successful factoring relationship will save you time, headaches, and money. It isn’t always just about the rate.

If you are considering using invoice factoring for your ongoing operational capital needs remember it should only be used as a temporary bridge towards securing conventional (bank) financing. By factoring your accounts receivable to get through a intense growth period you can effectively maneuver through the tough cash squeeze stage as the business gains traction. Access to capital is always the most important aspect to growing a successful business. As mentioned previously, securing bank financing too early may not qualify you for the proper level of financing which could leave you high and dry.

Accessing working capital by factoring invoices is a valuable solution until you build enough revenue assets to qualify for the size of loan that will allow stability. Factoring should be considered as a strategy to get to the next level, not the end all be all of your financing needs. Factoring is a necessary step that brings credibility to your operation by showing that you have the required resources and capabilities to deal with your obligations.

In the prior post we talked about direct payments to the factoring company. When a client purposefully or otherwise tells the customer to pay them instead of following the instructions to pay the factor, this is called ‘mis-direction’ of funds. This will cause a default of the factoring agreement. Mis-direction is the severest no-no in the factoring world. The factoring agreement will allow the factoring company to immediately call each and every one of your customers and demand that all payments owed to your company be paid directly to the factor. Mis-direction is simply not tolerated and is penalized severely.

Yes, from time to time a customer will mistakenly send a payment to the wrong address. The proper procedure in these cases is to contact the factor, photocopy the check and overnight it to the proper ‘remit to’ address in care of the factoring company. It’s only in egregious situations when the client has been withholding information that they deposited the customer payment long ago that those severe remedies are called into action. Having financed so many invoices over the years, it is pretty easy to spot the bad magician who thinks they can get away with a little mis-direction.

When a factoring company makes an advance on your invoices, it is important to understand that the repayment of the advance comes directly from the payer of the outstanding obligation. In other words, we pay you and your customer pays us back. This is the simplicity of using receivables factoring to grow your company. Critical to the ongoing factoring relationship is every payment towards an invoice that has been financed gets repaid directly to the factor. The customer will receive instructions you have assigned the proceeds of your invoice to a third party. The customer will understand they can continue to make the check out to your company, they only have to mail the check to a new ‘remit to’ address – or in the case of ACH wire transfer payments, the routing and account number will need to be changed. This helps so the customer does not need to create an new vendor account in their bookkeeping.

This is the crux of the factoring transaction, we pay our clients and their customer pays us back. Once we receive the customer payment, that transaction is retired and we move on to the next one. This keeps the ongoing relationship simple and easy to work with.

It is common for small businesses to go directly to a bank for outside capital without fully considering the big picture strategy of growth and the future. Yes, ultimately in the long run securing a conventional loan from a bank will be your goal, but let’s consider some of the downsides of going too early.

A bank is all about history, not the future. This largely means reviewing tax returns and your large contracts track record. What can you prove you have been able to deliver? Many small companies that struggle to get going lack this sort of history. A bank is interested in consistency. This shows up in the year in year out income streams – does your accounts receivable aging report show wild fluctuations? Again, small businesses in a growth trajectory usually show peaks and valleys in their income. How will the bank adjust to conform with your financial history?

And then there is liquid collateral. A bank wants to be able to sell off something quickly in the worst case scenario – for example some equity in your personal residence. So there is pressure for the bank to meet the necessary collateral standards. All this taken into consideration usually will result in a conservative approach when deciding to approve your business financing.

So it would seem obvious what insufficient access to capital will do to a business – slowly starve it. When sitting down with your advisers you may be better off to consider receivable factoring as a half step to achieving the goal of a bank line. Used temporarily, to be better positioned for a suitable line is what factoring is meant to accomplish. Access to capital, flexibility, no personal collateral, quick turnaround, these are some of the benefits when working with a factoring company as a step to graduating to further capitalization.