What’s Factoring in Business?

In my normal course of daily activities, I talk to a lot of entrepreneurs and business owners. We discuss everything from how they may have gotten started in their particular line of business, current production and sales activities for their company, business processes, the state of the economy, and the general outlook and prospects for future success of their enterprise. Eventually, the conversation always turns to finances, and ultimately, cash flow. Invariably, my prospects will ask the question “What is Factoring?”

Factoring may mean different things to different people, but essentially factoring is the sale of accounts receivables at a discount to a finance company. If you own a small business, you typically sell your product or service to a client with payment terms in the future (i.e. net 30, net 60, sometimes net 90 days). Essentially you are providing free financing terms to your clientele in order to sell your products or services to these clients. Merchants who offer credit card payments use factoring all the time – when they swipe the credit card at the point of sale, they are willing to give up a percentage (from 1.75% – 3.5%) of the sale to receive immediate payment. The purchaser of the goods pays the finance (credit card) company the full amount, and the finance company pays the merchant a discounted amount.

Factoring dates back some 4,000 years, to the cradle of civilization. Almost every civilization that valued commerce has practiced some form of factoring, including the Romans, who were the first to sell actual promissory notes at a discount. Prior to the 1930’s, factoring in the US occurred primarily in the textile and garment industries. After the war years, factoring companies saw the potential to bring factoring to other forms of invoice-based business and the expansion began.

So how does factoring accounts receivables benefit a business owner? In other words, why would you sell a current asset at a discounted price to a finance company? Wouldn’t it make sense to simply wait the 30, 60, or 90 days for the client to pay the invoice? The answer always relates to the time value of money, and having sufficient cash flow on hand to sustain operations until client payments are received.

Let’s explore one industry where factoring is heavily used, and is very beneficial: Temporary / Contract Staffing. The concept of temp staffing is simple: Find clients that are willing to accept your candidates for temporary or contract assignments, sign a contract with those clients, find the right employees for those jobs, secure the proper insurances in order to send your employees on assignment, hire the employees, send them out on assignment, then bill for your services. Believe me, there is TONS more involved in the process, but for now, we will stick with the basics. So, you’ve gotten the contract, put the employee on your payroll, sent the employee out on assignment, and have sent an invoice for your services. But there’s a catch… your employees wish to be paid weekly for the work they are doing, and they are your employees, so they will expect a paycheck after week 1. However, your client invoice will not be paid for 30, 60, up to 90 days later. The national average is approaching 45-50 days, so we’ll say that invoice will be paid in 48 days, or six weeks later. If you continue to send this employee out on assignment, he or she will still expect to get paid weekly. In the meantime, rent, telephone, internet, advertising, and other costs are coming due and you still haven’t received payment 1 from this client. Multiply employees by 10 or 20, and clients by 2, 5, or 10, and you can see where you may need some cash flow in order to “carry” your working capital costs.

In steps a factoring company. You have a current asset on the balance sheet – an accounts receivable, or future payment due from your client. How do you take that current asset and turn it into cash immediately so that you can continue to run your business? The finance company will step in and purchase that receivable immediately, at a discounted rate, which will give you the cash to operate your business. Then, the finance company will wait the 30, 60, up to 90 days later for your client to pay that invoice to them. You get the working capital you need to sustain and grow your business, the finance company earns a fee for “fronting” the monies, and business moves on.

Most factoring companies also offer additional services such as credit checks on potential new clients, collections assistance, and some even offer computer / back office services, depending on the industry. Most will also offer cash management reports, as well as generate accounts receivables aging reports in order to keep a company abreast of outstanding obligations, by client, and by age. Again, giving up a small percentage up front in order to sustain, maintain, and grow your business may make a lot of sense, especially in today’s economy.

If you would like to discuss your current cash flow situation, you may contact Dale Busbee, VP of Business Development at Prosperity Funding at (985) 641-8817, or via email dale@prosperityfunding.com.