How Factoring Works

Factoring is a hot topic these days, especially given the constrained credit markets. But many business owners still aren’t quite sure what factoring is or whether it’s right for them.

The main thing people want to know about factoring is: What is the cost-benefit equation? This is by far the biggest misunderstanding most business owners and even finance professionals have about factoring. The problem is that they often try to translate the cost of factoring into an annual percentage rate. But this results in an “apples-to-oranges” comparison, says Sarsha Adrian, a senior consultant with Graber Associates.

Instead, the cost of factoring needs to be viewed as a percentage of sales, because the factor provides many more services than financing alone. A factor essentially takes over all of the company’s accounts receivable operations, including credit checks, posting and ledgering of payments, and professional accounts receivable management.

“You can’t view factoring like you would bank financing,” Adrian says, “because you’re integrating the factor’s accounts receivable services into your business operations to reduce these costs and increase efficiency.”

Here are answers to some of the most basic questions when it comes to factoring today.

What Types of Paperwork and Documentation Are Required?

When weighed against traditional bank financing, there’s really no comparison. “Banks require a lot of paperwork and documentation in order to analyze a loan request, and they often take their time in making a decision,” says Adrian. “The main thing a factor wants to see is your customer invoices. Factors have sophisticated systems that gauge the credit quality of these invoices -- they are laser focused on what they’re looking for.”

How Does the Process Work?

In most factoring arrangements, a business’s customers will begin mailing payments directly to the factor, rather than to the business. Adrian says that some companies are a little uncomfortable with this at first, but once they understand the process, they usually see why it is the most efficient method. “Also, payments can be sent to a post office box or lockbox so that it’s not apparent they’re not going directly to the business.”

Some factors also offer what’s known as non-notification factoring, in which invoices are not ledgered with the factor’s remittance advice and the only change customers may notice is a new lockbox address. Non-notification factoring is usually best for companies that maintain a stable balance sheet and are in an industry that does not typically utilize nontraditional financing. All of the services available in a full-notification factoring facility are also provided with non-notification.

How Do You Find a Factor?

Adrian says that most factors specialize in certain types and sizes of businesses, “so companies should try to find a factor that’s best suited to meet their needs.”

A factor will become an integral part of your business team, therefore it’s important to perform careful due diligence when selecting a factor and investigate potential candidates thoroughly. For example, how long has the factor been in business? How well-capitalized is it? How many local businesses have used the factor? Professional experience and adequate capitalization are especially important.

Adrian says that banks often refer their clients to factors when they aren’t able to meet the client’s financing need. “Many banks today are building relationships with factors so they can refer clients to them and help make sure their financing needs are met, even if it’s not the bank that’s meeting the need directly. Most banks would rather offer a solution than have to turn a customer down.

“Factoring is much more appealing now than it used to be for a sizable segment of the financial world,” Adrian says. “I believe that factoring has become more mainstream and acceptable to an increased number of business owners and treasury professionals.”