The Advantages and Disadvantages of Factoring
The benefits of factoring
The factoring services consist of four main functions:
- Finance for the supplier; the factoring company pays the client the amount necessary for his working capital, in exchange for his invoices.
- Maintenance of the receivables account; the factoring company manages the trade debts of the client, keeping the sales accounts ledgers and sending out the invoices.
- Collection of receivables; the factoring company collects the payments due from the debtors of the client.
- Protection against the default in payment by debtors; the factoring company carries the risk of any bad debt (if the debtor fails to pay)
a. Establish a strong foundation
Establish a strong credit history. Factoring can be an essential tool for establishing a positive credit history by facilitating timely payments to suppliers and reduction of debt to creditors.
Meet financial obligations. Generating predictable cash flow can enable a company to consistently meet all financial obligations, and avoid the possibility of bankruptcy due to inadequate working capital.
Avoid new liabilities. Factoring is not a loan, but the sale of an asset (the invoices), and as such, does not add any new liabilities to a company's balance sheet, which means a stronger financial picture of the company. With factoring, the rigidities of traditional funding are removed, the funding grows with the company, making it capable of taking advantage of business opportunities, which require ready available cash. For companies that either cannot qualify for traditional debt financing or that simply do not want to incur more debt, factoring is a good alternative means of short-term financing.
In conclusion, factoring means flexible funding linked to current and future trading levels and needs. This is in contrast to traditional financing, which is based on historical balance sheet ratios.
Consistently make payroll. When payroll is due weekly, but the invoices issued to the customers are on trade credit, which means they are paid after 30-60-90 days or more, factoring can provide the funds to meet this basic operating cost on a regular basis.
Make timely tax payments. Factoring provides also funds that can be used to meet tax obligations, allowing a company to avoid liens and penalties from underpayment.
Weather seasonality and downturns. Companies can use factoring funds to cover operating costs, especially when customers are delaying payments beyond normal terms or demand has diminished temporarily.
Retain customers and employees. Predictable cash flow for delivering goods and services to customers and for meeting obligations to employees, increases retention rates and reduces turnover costs, improving the stability of an organization.
Improve credit monitoring. Factors provide critical analysis of customer creditworthiness to clients on an ongoing basis, enabling improved customer selection and the avoidance of large losses, which eventually means improved security for the company.
b. Maximise profitability
Reduce supplier credit costs. A company can pay suppliers more quickly with funds received through factoring, reducing or even eliminating the costs of supplier credit.
Take advantage of supplier discounts. Factoring funds can be used to purchase supplies on discount terms (volume or cash purchases), thereby reducing the costs of raw materials.
Qualify for preferred pricing. After paying suppliers in a timely way for a certain period, companies can often negotiate advantaged pricing.
Improve money collection. Factoring companies are expert in managing the money collection process, meaning reduced collection costs, faster collection times and improved overall collection rates with lower bad debt expense.
Faster paying customers. A recognized benefit of factoring is that some customers, knowing that a factoring company is involved, are willing to pay their invoices faster so that their credit rating is not impaired. Factors usually report payment history to credit agencies, which establish the credit rating for most businesses. From the point of view of the adherent, faster paying customers should mean a lower factoring fee.
Pay down debt. The money obtained from a factoring contract can be used for the company's debt reduction, which in turn reduces interest expense and finance fees for the company.
Eliminate early payment discounts to customers. With the ability to convert receivables into cash through factoring, there is no need to offer early payment discounts to customers, which are often a more costly and much less effective approach to generating the needed cash flow Retain equity and control. Factoring provides funding without the sale of company equity or the loss of operating control.
Continuous source of operating capital. The money received from factoring are directly tied to the sales of the company, which means that if the sales increase, also the money collected will amount higher and will be available for further investment in the company.
Investment in technology. Capital from factoring can be used to upgrade or acquire new technology that can increase productivity and improve quality, thereby reducing operating costs and even increasing sales.
Improve business planning. With stable and predictable flow of cash, management of the company can focus on operations, strategy and planning for the future of the company.
Credit screening. A factor will provide the company with credit information on any business that might be considered as a potential new customer, enabling the company to make good credit decisions.
Invest in training and service. More efficient employees and improved customer service can reduce operating costs and increase customer satisfaction.
c. Capture growth opportunities
Operate at full capacity. With factoring, working capital becomes available to add labour and materials so that a more efficient, full level of production can be achieved.
Purchase additional inventory. Factoring funds can support the purchase of inventory, which in turn means more products available to the customers.
Invest in sales and marketing. By using additional capital to generate new business, a company can increase market share and corporate profits.
Invest in product development. Investment in new services and products helps a company to remain competitive and often establish a market advantage, allowing it to ask for premium pricing and higher profit margins.
International business. Factoring can be an efficient way to minimize the cost and risk of doing business overseas. Export factoring may facilitate exporting to countries where the factoring company has a correspondent.
Fill larger orders. Working capital reserves through factoring can provide the resources to accept and produce new large orders before full payment is made.
Extend credit to customers. Working capital from factoring can be used to support credit purchases by customers, thereby increasing volume with current customers, and allowing sales to new customers that require credit terms.
Qualify for increased supplier lines. With an improved financial position and payment history, increased supplier lines can become available to provide additional support to growth efforts.
Disadvantages of Factoring
The cash price of the invoices is discounted by the factor company, the upfront cash price being usually 70-90% of the face value, depending upon the credit history of the customers and the nature of the adherent's business. The initial price is treated as a cash advance and the adherent typically receives an additional portion of the face value when and if the invoices are collected. The longer the invoice period, the higher the rate. And most factors will not take invoices with longer than 90-day paymentperiods. The final price is usually between 90-95% of the original invoice amount. The adherent's final cost might exceed the amount paid as an interest rate on a short - term commercial loan for an equal amount.
The adherent needs to take into account, before concluding a factoring contract, the size of the annual minimum fee, the length of the commitment period and notice period, and to make sure that factoring is a truly cost -effective decision for the company.
The adherent companies may find that, once they rely upon the services of a factor, they may be „locked in" to the relationship even when conditions improve, because of the cash flow implications of any arrangements.
b. Possible harm to customer relation
The factoring company may be in charge of the invoice collecting; in such circumstances, the adherent should pay attention to the money collection methods the factors employ, so that their personal relationship with their customers will not be impaired.
c. Company image distortion
In the past, when a company employed the services of a factor, it was considered a sign that the respective company was in financial difficulties. These days, however, the perception has changed, and factoring is considered a normal way to do business and a viable cash management technique.
d. Factoring may impose constraints on the way you do business
For non-recourse factoring, most factors will want to pre-approve the adherent's customers, which may cause delays in concluding new orders. Also, the factor will apply credit limits to individual customers.