By
Judy Hartcher*
Accessing
finance can be a real problem for many small businesses, especially
if they are growing fast. One option many businesses don't consider
is factoring, or cashflow lending as it is sometimes called.
While not
suitable for every business, factoring can provide a revolving
line of credit and a reduction in administrative costs.
Factoring
involves the sale of a business' book debts on a continuing basis.
Usually, the factoring firm will buy the business' sales invoices
at a discount of between 70 and 90 percent. The factor then collects
the invoice amounts from the business' customers. The business
receives the cash, less the discount, from a credit sale quickly
(usually within 24 to 48 hours) and maintains a healthy cashflow
even though the debtors may not pay for the sale for another 60
days or so.
Usually, the
factoring firm takes the difference as profit, however some factor
companies prefer to provide a percentage up front, the remainder
on collection, and charge interest and fees on the transaction.
Factoring
has become much more widely accepted in Australia with factoring
and invoice discounting turnover exceeding $11 billion in 2000.
In fact,
the use of credit cards in the retail industry is a form of consumer
factoring, where the retailer is paid immediately for goods or
services and the credit card company collects the payment from
the customer. Some Australian banks offer cashflow lending but
have generally found limited interest in the products - with many
businesses put off by higher interest rates charged to reflect
the risk of lending against assets not secured by property.
Several
Options
Factoring
firms can offer several levels of service. The premier service
usually involves taking over the complete management of the business'
accounts receivable, including administration, confirmation, and
collection of invoices, regular reports and monthly ageing reports
on all accounts processed.
This is usually
coupled with a seamless, confidential service, where the customer
of the business is unaware of the relationship between the business
and the factor and all communication between the factor and the
customer is branded as the business. In other cases, the factor
may only take over aspects of the accounts receivable function.
The level
of service provided by the factor is often related to the value
of the debtors book.
While it may
appear complicated at first, outsourcing accounts receivable can
significantly reduce costs. More importantly, it is particularly
useful for businesses that are growing or moving in a different
direction with a view to improving profitability. A growing business
can quickly outgrow an overdraft secured by fixed assets, yet
it may not be able to obtain finance on an unsecured basis.
A business
may also need the flexibility to cover sudden increases in order
levels. Factoring provides funding in line with sales growth.
This form
of finance can also be useful for start-up businesses that need
to pump cash back into their business to build their inventory,
but have difficulty obtaining overdraft or working capital facilities
due to a lack of trading history. Other businesses that may find
factoring worth exploring are those in a GST refund situation,
or those where debtor turn is slower than creditor turn.
Service, manufacturing
and wholesale businesses are often suited to this type of finance.
Businesses
that mainly sell on cash terms to the general public may find
credit cards or overdrafts more cost effective. Those with complex
products or terms of sale such as trial and return clauses or
those in the construction industry, where customers are invoiced
in stages, are also less suited to factoring due to the complexity
of the supplier/customer relationship.
Pros &
Cons
As with all
business finance, factoring offers advantages, disadvantages and
potential pitfalls.
The level
of benefit from factoring will vary from business to business.
But it usually
provides:
* Immediate cashflow access to 70-90 percent of the value of
debtor invoices.
* Working
capital for growth without requirements for a strong balance sheet
or substantial net worth.
* A good
interface with the supplier and, as a result, a seamless transaction
for the customer.
* Outsourced
debtor administration and associated cost savings.
* The
ability to increase sales by offering credit which the business
may have been unable to fund otherwise.
* The ability
to take advantage of creditor discount terms, improve credit rating
by being able to pay creditors promptly and an enhanced ability
to capitalise on larger orders as required.
* The option
to free up property from being tied as security.
Some issues
that should be considered if looking at factoring as an option
include:
* Complexity. Rather than simplify the account-keeping,
factoring may add complexity to the business depending on the
level of integration of account-keeping processes.
* Culture.
If the culture of the business and the factor are at odds, the
arrangement may interfere with the relationship with customers.
* Bad Debts.
In most cases, the business still wears the non-collection risk
and may end up following a restrictive process to maintain the
facility.
* Cost.
It can be expensive depending on the interest and costs charged
by the particular firm such as finance charges, administration
charges, mailing charges, stamp duty.
* Asset
control. Some factors take a floating charge over all the
business' assets not just debtors. Consequently a business may
need to obtain a release from the factor to sell any of its assets.
* Value.
The factor may only finance a percentage of the debtor value
and may undertake its own audit of the business' accounts.
* Customer
relations. A factor will usually take over the entire debtor
ledger which may cause difficulties if a business wishes to remain
in control of some accounts that are particularly sensitive or
vital to the business.
* Security.
Some factoring firms now require small businesses to provide property
as security in which case it may be cheaper and more effective
to arrange a bank overdraft.
One of the
most common traps for small businesses using factoring is the
assumption that outsourcing the function means outsourcing the
responsibility.
The benefits
of using a factoring facility still depends on good management
of debtors and the finances of the business. Every business must
manage their terms of trade, and ensure the terms they offer and
the credit they receive are appropriate for their particular business.
They need an effective debt collection system and simple internal
controls to prevent errors.
Factoring
could cause additional problems for businesses without a good
handle on cashflow management and cost budgeting. They may find
themselves in a downward spiral, spending debtor receipts on current
overheads and not paying the current creditors and tax provisions
such as GST, and then wondering what went wrong. They need to
understand the money flow of the business and use short-term funding
such as factoring on short-term assets.
With good
management, the use of factoring can be a very useful source of
finance particularly for a young business that is growing fast.
However, there are plenty of traps for the unwary, and as always,
if in doubt get advice before committing to any form of finance.
DSB
* Judy
Hartcher is a business policy adviser with CPA Australia.
