There is a myriad of reasons why businesses fail, but poor cash flow management and lack of access to working capital are the two major reasons. Maintaining positive cash flow and having access to working capital enables a business to meet its financial obligations. New and rapidly growing businesses are especially vulnerable to cash flow crunches. Banks traditionally fund based on the historical performance of a business. They are reluctant to provide financing to new and small businesses with low fixed assets and no or minimal equity. There is however an alternative to traditional bank financing named factoring.
Small or medium size enterprises (SMEs) may face many problems and market challenges in their efforts to develop and grow. With the many difficulties faced by the small business sector, the unique financial problems that overshadow the barriers hindering the small firm’s survival and growth pertain to credit rationing and finance gaps. The existence of this problem normally directs many businesses to seek different alternatives of finance for their operations. To alleviate such a problem, many firms have sought to pledge and finance an important element in their working, that of accounts receivable; a process known as factoring.
Around the world, factoring is a growing source of external financing for corporations and SMEs. What is unique about factoring is that the credit provided by a lender is explicitly linked to the value of a supplier’s accounts receivable and not the supplier’s overall creditworthiness. Therefore, factoring allows suppliers to transfer their credit risk to their buyers.
A challenge for many small businesses is access to financing. Many firms find it difficult to finance their production cycle, since after goods are delivered most buyers demand 30 to 90 days to pay. For this duration, sellers issue an invoice, recorded for the buyer as an account payable and for the seller as an account receivable, which is an illiquid asset for the seller until payment is received.
Factoring is a type of supplier financing in which firms sell their credit-worthy accounts receivable at a discount and receive immediate cash. Factoring is not a loan and there are no additional liabilities on the firm’s balance sheet, although it provides working capital financing.
Unlike traditional forms of working capital financing, factoring involves the outright purchase of the accounts receivable by the factor, rather than collateralize as a loan. Factoring appears to be a powerful tool in providing working capital financing to SME borrowers. Its key virtue is that underwriting in factoring is based on the risk of the accounts receivable themselves rather than the risk of the borrower. However, as much as factoring does not need collateralization of assets, access to historical credit information, which is necessary to assess the credit risk of factoring transactions and enforce factoring arrangements does matter.
The mechanics of factoring
In factoring, the underlying assets are the seller’s accounts receivable. It allows the sale of a company’s account receivables to a third party (the factor/financier) for immediate cash. It allows a business to unlock funds tied up in unpaid invoices, leading to an immediate injection of cash. On receipt of an invoice from a client, a factor (financier) typically pays up to 80% of the face value to the client. Factoring frees up working capital so the business can meet its financial obligations and take on more business.
Some pointers regarding factoring: