Why Do Companies Use Factoring?

Factoring is a product that helps companies that have slow-paying clients. These companies usually can’t wait 30 to 60 days to get paid by clients. Factoring solves this problem by financing their invoices. It provides businesses with cash that they can use to run the business. Companies often use the funds from factoring to:

  • Pay employees
  • Pay suppliers
  • Build inventory
  • Cover tax expenses
  • Start new projects
  • Get more clients

1. Why use factoring?

Companies can benefit from using factoring in the following seven situations:

a) Improve cash flow from slow-paying clients

The most common reason to use factoring is to improve cash flow due to slow-paying clients. Many companies must offer net-30-day terms to larger clients. However, the reality is that they can’t afford to wait 30 to 60 days to get paid.

Slow payments can create persistent cash flow problems for the business. These problems can get worse if the company is growing quickly. Factoring their accounts receivable provides companies with immediate funds for their invoices. This solution eliminates the cash flow problem and provides the liquidity to meet payroll and cover other expenses.

b) New companies, small companies, or startups

Cash flow problems can affect companies of any size. But smaller and newer companies don’t have the traditional options available to larger companies. Factoring can be a great alternative. It is easy to qualify for and can be used by small companies. The main criterion for qualification is the credit quality of your customers. New or small companies with great clients can often qualify for funding.

c) Turnaround situations

Getting funding while trying to turn around a troubled company is nearly impossible for small businesses. The company’s financial statements often don’t look good enough to get bank financing. Unfortunately, this time is when they need financing the most.

Receivables factoring can often help companies that are going through a turnaround. It provides a cash flow lifeline that enables the company to improve and become profitable again. Usually, the company is able to get a business line of credit (or similar product) once the situation improves.

d) Unable to qualify for a loan/line of credit

Loans and lines of credit are the cheapest forms of financing available to most companies. And in many cases, they are the best solutions for a company.

Getting conventional bank financing is difficult. Lenders provide funding only to companies with a good track record and solid financials. Furthermore, lenders also shy away from industries they deem “risky.” These industries include transportation and construction, among others.

Receivables factoring is an option for companies that can’t get conventional financing. It has simple qualification requirements. To qualify, you must have:

  • Creditworthy commercial clients
  • Good invoicing practices
  • Good managers

e) Out of covenant with current lenders

Loan covenants can make it difficult to maintain a loan or line of credit – even for good companies. Banks often use conservative covenants that don’t provide the flexibility some businesses need.

For example, seasonal companies often run into problems with their covenants. There is nothing wrong with the company, per se. It’s just that their financials don’t look as good as they should during the slow period. This “seasonality” causes them to fall out of covenant on their financial ratios.

Factoring can be a good solution for companies that encounter this problem. Most factoring lines have no (or minimal) covenants. Those that do have covenants have flexible rules that can accommodate most situations.

f) Less-than-perfect credit

Most lenders provide financing only to companies whose owners have good personal credit. This practice is understandable, but it leaves everybody else without a solution. Factoring companies have much more lenient requirements. They focus more on the company’s quality than on the owners’ credit. Companies whose owners have “less-than-perfect” credit can usually qualify for factoring.

g) Recent bankruptcies

Most lenders don’t provide funding to companies that have a recent bankruptcy. This is a challenging situation for these companies, as funding is often critical. Factoring companies can provide funding in many post-bankruptcy scenarios. The company must still meet the requirements for factoring, though.

2. How does factoring work?

Factoring finances slow-paying invoices from your commercial clients. Instead of making you wait 30 to 60 days to get paid, the factor pays you immediately. This payment provides you with the funds to run your company. The financing transaction settles when your client pays the invoice in full. Your client still pays on their usual schedule.

Most factoring transactions have two installment payments. The first installment covers 70% to 90% of the invoice. It is deposited in your account as soon as your client gets invoiced. Note that the invoice must be for completed services or a delivered product.

Once your client pays the invoice in full, the factor deposits the second payment in your account. This installment covers the remaining 10% to 30% that was not advanced initially, less the fee. To learn more, read “What is Factoring?” and “How Does Invoice Factoring Work?

3. How much does factoring cost?

Factoring costs vary based on the size of the opportunity, the industry, and credit risks. In general, monthly costs range from 1.15% to 3.5%. These costs can be pro-rated to suit your needs. To learn more, read “How Much Does Factoring Cost?

4. What industries use factoring?

Factoring is used by most industries that work with commercial or government clients. Some industry examples include:

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