Factoring (finance) - Differences From Bank Loans

Differences From Bank Loans

Factors make funds available, even when banks would not do so, because factors focus first on the credit worthiness of the debtor, the party who is obligated to pay the invoices for goods or services delivered by the seller. In contrast, the fundamental emphasis in a bank lending relationship is on the creditworthiness of the borrower, not that of its customers. While bank lending is cheaper than factoring, the key terms and conditions under which the small firm must operate differ significantly.

From a combined cost and availability of funds and services perspective, factoring creates wealth for some but not all small businesses. For small businesses, their choice is slowing their growth or the use of external funds beyond the banks. In choosing to use external funds beyond the banks the rapidly growing firm’s choice is between seeking venture capital (i.e., equity) or the lower cost of selling invoices to finance their growth. The latter is also easier to access and can be obtained in a matter of a week or two, whereas securing funds from venture capitalists can typically take up to six months. Factoring is also used as bridge financing while the firm pursues venture capital and in conjunction with venture capital to provide a lower average cost of funds than equity financing alone. Of course one needs to note that Equity capital has the highest cost in the long run, as a firm needs to demonstrate higher return on investment for its shareholders Firms can also combine the three types of financing, angel/venture, factoring and bank line of credit to further reduce their total cost of funds whilst at the same time improving cash flow.

As with any technique, factoring solves some problems but not all. Businesses with a small spread between the revenue from a sale and the cost of a sale, should limit their use of factoring to sales above their breakeven sales level where the revenue less the direct cost of the sale plus the cost of factoring is positive.

While factoring is an attractive alternative to raising equity for small innovative fast-growing firms, the same financial technique can be used to turn around a fundamentally good business whose management has encountered a perfect storm or made significant business mistakes which have made it impossible for the firm to work within the constraints of their bank covenants. The value of using factoring for this purpose is that it provides management time to implement the changes required to turn the business around. The firm is paying to have the option of a future the owners control. The association of factoring with troubled situations accounts for the half truth of it being labeled 'last resort' financing. However, use of the technique when there is only a modest spread between the revenue from a sale and its cost is not advisable for turnarounds. Nor are turnarounds usually able to recreate wealth for the owners in this situation.

Large firms use the technique without any negative connotations to show cash on their balance sheet rather than an account receivable entry, money owed from their customers, particularly when these show payments being due for extended periods of time beyond the North American norm of 60 days or less.