The practice of factor financing improves cash flow and is the life-blood of many small businesses. With factor financing, a company sells its accounts receivable to a financing company, known as the factor, for immediate cash. The factor pays out a percentage of the value of the invoice, which can be anything from 70 to 90 percent depending on what is negotiated. The company using the service gets the benefit of immediate cash, instead of waiting for the 30 to 60 days or more that their debtors would take to settle the invoice.
Factor financing is often mistakenly viewed as a last resort tactic for a company with a bad credit record. While it is true that factors don’t make decisions based on the credit worthiness of the company requesting financing, but rather the debtor’s creditworthiness, factor financing can rarely save a company from going bust if that is the way it is headed – at best it may delay the inevitable. Factor financing is, however, a valuable tool for start-up companies and for companies who have tardy debtors that make a habit of late payment of invoices.
The downside of factor financing is that it is expensive, often making it impractical for businesses running on small profit margins. However, when considering that the factor takes on the role of accounts receivable and responsibility of debt collection, this essentially does away with the expense of hiring a credit controller and to an extent counteracts the factor financing expense. It also saves the small business owner a lot of time which he can focus on other aspects of his business.
There are two main types of factor financing – non-recourse and recourse. A non-recourse factor will take on all the risk involved with the invoice they are buying. If the debtor defaults on payment, the factor picks up the tab. This is the most popular choice for small businesses, but it is also, quite understandably, more expensive. A recourse factor has lower fees, but if the debtor defaults on payment it becomes the debts reverts to the business owner. In general, a debtor will be advised that his debt has been sold to a factor because correspondence and monthly statements will come from the factor and not the company that made the sale or provided the service in the first place.
The current financial crisis has put the spotlight on factor financing, making it an attractive option for small business owners desperate to raise cash. A recent survey by a US trade group indicates that US factoring is experiencing strong growth. Factor financing companies have also reported that there has been an increase in bogus invoices, making it imperative for financers to do their homework when it comes to the creditworthiness of the debtors whose debt they will be buying.
Factor financing is one of the services offered by the CIT Group which is reportedly heading for Chapter 11 bankruptcy. No doubt CIT clients and investors will be interested in future developments.