Where to Go When the Banks Say No

In today’s economic environment, it is an understatement to say it is challenging for a small business owner to obtain traditional bank financing or increase his or her current loan commitments. Banks have been tightening their credit standards during recent years and will continue to do so for the foreseeable future. Credit lines are being reduced, and capital to fund growth and new business opportunities is very limited unless you are willing to give up equity, which still is very difficult. Even businesses that have had strong relationships with their banks for 10-plus years are having trouble renewing their loan facilities on an annual basis.

Where can today’s small business owner find the capital necessary to keep his or her business going, take on new growth opportunities as they pre-sent themselves, keep vendors current and meet weekly payroll? One answer is accounts receivable financing.

What Is It?

Accounts receivable financing, or factoring as it’s historically known, is a way to fund working capital fluctuations and cash-flow needs of a business. Although it still is relatively unknown in today’s mainstream financial world, factoring has been around for centuries. It has played an important role in business dating back to the pre-1400s.

No matter what you call it, factoring, accounts receivable financing, A/R funding or growth capital is a way to utilize a business’s accounts receivables to finance its cash-flow needs. Funding is provided to clients based on their accounts receivable balances and invoices generated today, though the invoices may not get paid for 45 to 90 days or longer.

Let’s assume a remodeling business has $50,000 in accounts receivables due in less than 90 days. Most factors (privately held finance companies) provide an advance rate of 75 to 85 percent of the invoice amount, depending on industry and underlying credit review. In this example, the remodeling business would be able to borrow up to 85 percent of its $50,000 in receivables, or $42,500.

Let’s further assume the invoices are paid in 60 days. The factor will have set up a lockbox account it controls to receive payment. The $42,500 that was advanced 60 days earlier is paid back, leaving a balance due back to the remodeling company of $7,500, less the factoring fees. Factoring fees typically are 2 to 4 percent per month, depending on the overall risk as determined by the factor. Each factoring transaction is invoice specific, rather than an overall credit line as offered by banks.

In this example, the remodeling business was able to borrow $42,500 upfront, as opposed to waiting 60 days for the invoices to be paid. This allows for opportunities to take advantage of vendor discounts, which can offset a large portion of the factoring fee itself. For example, if a vendor offers a 3 percent discount if it is paid within 10 days, that vendor discount can offset the remodeling business’s factoring fee if it is 3 percent. Factoring also provides immediate cash flow and working capital to meet payroll and buy materials for the next job, as well as eliminates calling customers weekly to ask for their payments. Most importantly, factoring allows business owners to concentrate and focus on running their businesses.

Getting Approved

Although banks are focused on profitability, balance-sheet leverage, equity and financial ratios, factors primarily are focused on the credit quality of a business’s customers. In factoring, customers (debtors) are the key to determining whether a factor will provide funding to a business. Debtors also determine how much funding will be provided.

Receivables also must be verifiable, meaning verification that the goods have been delivered or that the services have been performed is critical.

Factoring allows for greater borrowing power against a business’s current receivables by providing higher advance rates and greater cash flow, as well as fewer reporting requirements than banks typically need.

Most factors will require some or all of the following information:

  • Current accounts receivable aging
  • Articles of incorporation
  • Current-month financial statement
  • Current accounts payable aging
  • Most recent business tax return
  • A standard application

Upon review of this information, the factor will order credit-agency reports on a business and the debtors it wants to use for factoring. The application requires the debtors’ signatures, authorizing the factor to obtain credit information. The factor also will review individual credit reports of the majority owners of the business. The factor then will order a Uniform Commercial Code search to ensure no other lender has the receivables the business pledged as collateral.

Based on this review, the factor will determine whether a business qualifies for accounts receivable funding. Upon receipt of the necessary information, a decision typically can be made in two to five business days, and funding can occur within 10 business days. As long as a business has good customers who pay in less than 120 days, and the business owner’s credit score is average, then the business typically is approved.

In many cases, the factor acts as a business’s internal credit and collections department. The factor will make collection calls on past-due invoices and work with the business owner to collect payment from customers as quickly as possible.

Consider Factoring

Factoring is more expensive than bank financing for several reasons. First, most factors are privately held small businesses; their funding comes from banks and private investors. As a result, the cost of funds for the factor is much higher than it is for banks, which borrow from the Federal Reserve at nominal rates. Second, the risk is higher, so businesses that use factoring pay for that risk factor.

It is important to remember, factoring is not a loan, which is a debt on a balance sheet and costs interest. Factoring is an advance against a business’s invoices and puts cash into the business’s bank account without creating an obligation to pay it back because the business did not borrow money; it sold an asset.

Although there are higher costs in factoring, the benefits provided can be much greater and offset those costs. Knowing a funding source is available today and tomorrow, even if the business is going through a down cycle or losing money for a period of time, can provide much-needed relief. As long as businesses are performing valid work and have verifiable goods or services, factors will continue to fund them in down times and growth cycles. That can mean everything to many small business owners.