Factoring: 5 Things You Need To Know

Factoring used to have a stigma -- many considered it a last resort for businesses, somewhere between a liquidation fire sale and bankruptcy. But both the practice and the perception have changed in recent years, and those who still readily dismiss factoring probably don't fully understand it.

Here's how factoring basically works: A bank or other financial institution purchases a company's outstanding accounts receivable or invoices at a discount, giving that company quick access to cash.

Think factoring could help ease some of your financial woes? Here are five things you need to know.

1. Know the definition of factoring.
Say you're an entrepreneur selling a line of clothing to a major department store (factoring is very popular in the retail industry). You deliver the clothes and send out an invoice. Your factor -- a bank or other financial institution -- then pays you a portion of your invoice, usually 75 to 80 percent, right away.

The factor collects the invoice from that major department store and forwards the rest of your money, that remaining 20 or 25 percent, minus its fee, which is generally around 2 to 6 percent. So if you have a $50,000 order you're waiting on, your factor will end up with $1,000 to $3,000 of that.

Factoring can help businesses better manage cash flow, especially with slow-paying clients. But there are other reasons, too. "Some companies don't want to have a credit department," says Louis J. Cappelli, chairman of Sterling National Bank in New York. "They're shipping merchandise all over the country. Effectively, they're outsourcing the credit and collection function."

In other words, you or your employees don't have to chase down the business or individual that owes you money. Your factor will.

2. Factoring is now acceptible.
Factoring used to be looked down upon because hiring a factoring company was a little like hiring a tough guy. The client would probably pay up, but chances are, you wouldn't be working with that client again.

Today most, if not all, national banks act as factors for businesses -- it's considered part of "asset-based commercial lending." One reason is that banks, financial lenders and the factoring companies that exist now realized that while big companies may be late with payments, most of them are going to pay eventually. A small business may not be able to afford to wait around while Walmart or Macy's gets around to sending out that invoice, but a bank can -- and if it takes too long for that invoice to come around, they'll remind them.

And the accounts-receivable department at any major company you're working with isn't going to think any less of your company if it receives a letter or a call from a factor. They know all about factoring and accept that occasionally hearing from them is just part of doing business.

3. Factoring can be a useful predictor.
A bank decides whether you're a good credit risk and if they'll loan you money based on your financial past. A factor decides whether to advance you money based on your future. So if a factor is willing to purchase your invoices -- they see money in your future. They recognize, as you do, that things are looking up.

There's another way factors can offer insight: A reputable factor (like any organization you work with, you have to do your due diligence) will investigate the creditworthiness of any company that owes you money. If you're owed by a major corporation, then obviously your factor likely already has a file on it, and odds are, it isn't having money problems and your invoice will be purchased.

If you're owed by a smaller entity without a renowned reputation, a factor is a good way to discover whether you're likely to be paid. If your factor refuses to buy your invoice, you may be working with a company that's going to give you problems down the road.

4. A plus: Factors assume most of the risk.
This isn't a loan. If you have a $50,000 order, and your factor initially gives you $37,500 (75 percent), and then somehow the major department store you're working with goes out of business and can't pay that $50,000 invoice, the factor is out the $37,500 that they paid you. Typically, you won't receive any more money from the factor -- that is, the remaining 25 percent minus the fee. But, again, you won't have to pay back the factor $37,500, and, of course, if you hadn't used a factor, you'd be out an entire $50,000.

5. A minus: Factoring comes with a cost.
If you're using a factor to handle all your invoicing, that's 2 to 6 percent of your business income you're ultimately losing. "Smaller businesses and entrepreneurs typically don't have a full understanding of the cost they're going to be paying," says Paul Hahn, a partner at Golenbock Eiseman Assor Bell & Peskoe, a New York-based law firm. "Smaller factors often charge higher rates, so the entrepreneur has to look at the impact of the cost of these funds over the long haul. You've got major companies with hundreds of millions of dollars that factor, and they do it because they don't have to have a credit department, so the commission they pay is more than offset by not having a credit and collection department." In other words, for many big businesses, factoring is a cost of doing business and, in a sense, outsourcing.

But if you're a small business that isn't invoicing hundreds of millions of dollars, factoring may not work for you. Like any business practice, you'll have to crunch the numbers. Also, consider hiring a company that offers invoice discounting, which is a very similar process to factoring -- one of the main distinctions is that any collecting is done by the small business. (Interface Financial Group is a franchise that does invoice franchising.) Because you're collecting, the charges for invoice discounting a little lower than factoring. And invoice discounters will usually advance you more of your money -- up to 90 percent -- than the factoring companies will.

The original version of this article appeared on AOL Small Business on 1/23/11.