When a business needs to raise instant cash, it is often the loans market which benefits. However, taking out a bank loan can be a long-winded process and may even be impossible if the business is new or has had a rocky financial past. Even if a loan is granted, there are sometimes restrictions on how the raised cash can be spent. The business is also then in debt to the bank or loan company.
As an alternative, many businesses use factoring. There are different types of factoring models but at their heart is the same concept: the sale of future payments as an asset.
Standard Invoice Factoring
When most people think of factoring, standard invoice factoring is what springs to mind. This is the sale of a business’s accounts receivable for upfront monies.
When a business provides a service or sells a product they will generally invoice the customer on standard terms of between 30 and 60 days. As every business owner knows, this time period sometimes stretches to 90 to 120 days or more depending on the customer.
This payment delay clearly creates financial pressure on the business which still has to pay its day-to-day running costs. Rather than resort to loans or aggressively chasing customers, a company can sell the value of those future payments to a factoring company who will do the chasing for them. The invoices are, in effect, paid on time by the factoring company (minus a discount) and, providing the customer pays up, there is no business debt created. Factoring is also an ongoing arrangement and as the business grows in size, so the availability of invoice funding increases; there is no need for a new application.
Some factoring companies even offer non-recourse factoring in which they also take on the liability of defaulted payments. However, these will have more stringent requirements due to the extra risk involved.
With the exception of non-recourse invoice factoring, there is always an element of risk that the customer will default and that the supplier will have to reimburse the factoring company (termed ‘making the factor whole’).
With reverse factoring, it is the buyer – usually a large firm – which takes on the risk. Reverse factoring is a three-party agreement whereby the factoring company will pay the supplier on behalf of the customer. The factoring company will usually negotiate with all of the customer’s supplier to agree on which invoices require early payment (often within 10 days). The supplier benefits due to a more managed cash flow and a reduced discount (as opposed to the standard trade discount). The buyer benefits as they can set up a regular payment to one source (the factoring company). As well as securing their discount, the factoring company also benefits by building up a rich database of contacts.
Although it is not strictly factoring, invoice discounting is another popular way for businesses to manage their cash flow issues. Unlike standard invoice factoring, invoice discounting is managed by the business themselves although it is financed by the factoring company. This means that all communications, including customer chasing, and administration continues to be carried out by the business. This includes the generation of two invoices, one for the customer and one for the factoring company which will then send the discounted funds.
One of the benefits of this arrangement is that the customers are unaware of the arrangement and any cash flow issues the business is experiencing. The main disadvantage is the allocation of accounting resources.
Structured Settlement Factoring
Factoring does not only apply to businesses. Another take on factoring is where a company will offer cash for structured settlements. Structured settlements are a type of arrangement which is put in place following a court case found in favor of the plaintiff.
This form of recompense is often ordered when the injured party has ongoing medical needs and faces temporary or permanent loss of employment as a result of the incident. Rather than pay out one lump sum, the defendant’s insurer agrees to honor a schedule of payment which may include a mixture of lump sums and regular income streams. The insurance company will often enter into a reinsurance agreement with a larger insurer to mitigate against future economic challenges.
There are several scenarios whereby the beneficiary may want to access their money earlier. For example, they may accrue additional medical expenses or simply run out of cash for daily living. When this need arises, structured settlement purchasers will offer to buy the liability in return for a discount. Despite being highly illiquid, these products can be attractive to investors due to their rate of return and the fact that the payments are backed by a court and funded by highly capitalized institutions.
Real Estate Commission Factoring
Since the financial crash of 2008, some factoring companies have seen an opportunity to support (and of course profit from) the rebounding property market. The concept is fairly simple: brokers and agents selling prime real estate often have to wait a lengthy period of time to receive their commissions.
This can cause cash flow issues which effect everything from marketing and promotional activities to day-to-day expenses. Rather than suffer from a critical cash flow shortfall, the factoring company and broker/agent will draw up a contractual agreement between them. This will provide for a wired transfer of funds from the factoring company soon after a deal has been closed, sometimes within hours of the contract being signed. The factoring company will, of course, pay a reduced amount (e.g. 90 per cent of the commission) and keep the difference.
In reality, real estate factoring is nothing more than an industry-specific form of standard invoice factoring with the agent’s or broker’s commission treated as a form of accounts receivable. There are other types of factoring customized for the medical, construction and haulage industries.
Factoring can be the lifeline for a business struggling with cash flow problems, particularly if they have a chequered (or non-existent) history or don’t want to be indebted to the bank. As with all cash flow solutions, every business has its own unique needs and should get solid financial advice before moving forward.
Kathy Manson is a Finance Coach and Blogger. Currently, she is working on structured settlement payments at http://www.catalinastructuredfunding.com. She is very proactive and aware about each and every update of financial changes in the industry. On Twitter @ structuredfund.