Factoring: Fact and Fiction

Factoring can provide immediate cash when and where it’s needed

By Jane Erwin
The high tech personnel agency you manage has a unique opportunity to bid on a large contract – providing 50 engineers for at least six months – that will double your business all at once. While that may sound like the answer to a fledgling business’ prayers, it also poses a real problem. You’ll have to pay those workers weekly. But by the time you start getting paid by the customer realistically, 60days – you’ll have met payroll eight times. Where will that money come from?
The answer could be factoring.
Somewhat like a line of credit, factoring can provide immediate cash on an as-needed basis. Here’s how it works. A specialized agent, or factor, agrees to buy certain account receivables from you. The factor advances you that amount, minus a discount-depending on the credit worthiness of the customers involved, payment period and other variables. When the factor collects the receivable, he keeps the discount as fee for the nonpayment risk and for the time value of money.

For example, Smith Factor Co. agrees to buy your 30-day $1,000 invoice to ABC Co., advancing you $700. Thirty days later, when it collects the $1,000 from ABC, Smith pays you $250 and keeps $50 as its fee. If it takes 45 days to collect the account receivable, the discount increases. In this example, the factor might pay you $220 and take $80 as its fee.

Usually, a factoring company takes the position that if the account receivable isn’t collected within 60 days, it’s considered a disputed receivable, As such, it’s not what was contracted for, so you have to buy it back at full value. If the account receivable is never paid because the customer goes bankrupt and out of business, that’s not a problem. It’s part of the risk the factor assumes.

Factoring is a practical source of funding, usually readily available and flexible, according to Daniel Eke, a factoring specialist certified by the National Association of Factoring Professionals and owner of Houston-based Factor Funding Company.

Eke’s company is part of a nationwide network of factors that can pool resources. He works with all industries, in amounts ranging from $2,000 up to hundreds of millions of dollars.

“Factoring is good for businesses that don’t have hard assets, such as consulting firms or employment agencies,” Eke explains. “The credit of the customer (whose invoices the factor purchases) is what’s important.”

Typically, factoring is attractive to young and growing companies, particularly those with no track record or net worth for a bank loan. This type of funding can also be helpful to companies emerging from bankruptcy.

“If a company is growing rapidly doubling in revenue every year, for example – it typically can’t finance that growth through a bank” says John Minter, president of KBK Financial Inc.’s Houston division. “Most people think they have to give up equity in these situations. Factoring is another option.”

There are other uses for factoring. It turns receivables into immediate cash without creating new debt, solves cash-flow problems; makes capital available without regard to a client’s credit rating or balance sheet; gives a client the ability to take advantage of vendors’ early payment discounts; and offers analysis and ongoing monitoring of customers’ credit.

Many people think of factoring as a form of last-resort financing to be used only if you can’t get a loan elsewhere,” Minter says. “That’s a major misconception. We have many clients who could bank anywhere they want to, but choose to factor because of the flexibility it provides and because they like to keep a low profile. The fact that it’s truly off-balance-sheet financing is also appealing.”

However, factoring also has its cautions and critics.

“Factoring is similar to a prescribed medication. If it’s used properly and with correct supervision, it can be a significant cure. If it’s abused, it can destroy you,” says Phil Gootee, a lecturer in the University of Houston’s Executive MBA program and Small Business Development Center.

A downside is that factoring is expensive, with a 1.5 to 10 percent range for factor fees.

The problems with factoring is that it’s easy, expensive and most people don’t take the time to understand it completely,” says Gootee, whose consulting company, Strategic Operational Services, specializes in crisis management in the contract-surety industry.

“If you’re going to use factoring, you need a very clear plan of how you will use it and for how long; I’d say six to nine months at the most. You also need to consider if you have the profit margin to afford it. Three to five percent may not sound like much, but remember, you’re talking about 3 to 5 percent on a 30-day period. That’s 36-60 percent annually.”

Along with financial-services firms, several local banks also offer factoring.

Houston National Bank offers an in between service to assist with business funding. “Business Manager” is a receivables financing software program that allows the bank to purchase accounts receivable at a discount.

“We started about 1-1/2 years ago.” Says Phil Linton, Vice President of Corporate Services. “This is an opportunity to provide a unique service to help growing businesses and to help us compete in the marketplace. We’re interested in the business itself, rather than just trying to make money. We can use our program to help a business with receivables financing, then can help them move into other banking products.” Most Business Manager clients have less than $5 million in sales and fall into the trucking, service, manufacturing and wholesaling industries.

Unlike pure factoring, however, customers have to qualify for Houston National Bank’s program, similar to qualifying for a loan or line of credit. “We charge a flat fee based on the receivable amount – usually about 2-3 percent and don’t figure in the length of time,” Linton explains. “This financing doesn’t fit every business. It wouldn’t work for very new businesses with no equity or those that are financially flush.”

The key is knowing your business and needs.

“Use the type of funding appropriate to your need,” Gootee advises, “If you can afford a conventional loan, that’s probably the way to go. If you have high production costs and need to sell a product, consider factoring. Don’t let the need for money cloud your judgment.” DBA

Jane Erwin is a local free-lance writer.
Reprinted with permission of DBA Houston magazine
DBA Houston February 1997