Factoring Guide. Understanding the Principles

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1 Factoring Guide Understanding the Principles This report introduces factoring topics that every factoring candidate should know. It provides a concise, easy to understand presentation of the factoring application process and factoring procedures. The reader will be equipped to enter a factoring relationship and understand the processes required to successfully factor his or her business. Rick Hultz, President of Southwest Factors

2 FACTORING GUIDE UNDERSTANDING THE PRINCIPLES FACTORING TERMINOLOGY Factoring is a term that goes by several names including... Receivables factoring Accounts receivable factoring Invoice factoring FACTORING DEFINITION Factoring is the selling of your invoices or receivables to a factoring company (factor) for immediate cash at a discount (factoring fee). The factor usually withholds a reserve of 10% to 20% from cash for possible uncollectible payments. This reserve is remitted to you after the invoices are collected. The factoring rate is typically between 2% and 5%. Factoring is not a loan. Factoring includes receivables management and credit services. Factoring doesn t require the repayment of loan amounts. Factoring improves your cash flow dramatically without incurring debt. Factoring is not debt collection. Factoring is a form of financing to improve working capital, not an attempt to collect old debts. Factoring companies purchase receivables that are newly invoiced or less than 30 days old. Collection agencies buy debts that are 60 days or older. Factoring fees range from 2% to 5%. Debt collection fees range from 25% to 30%. HOW FACTORING WORKS Factor your invoices and receivables: 1. You send your invoices and related documentation to the factoring company. This is done with a Schedule of Accounts, also referred to as an Assignment Sheet. You will list the invoices you re factoring 1

3 and include the customer s company name, P.O. number (if applicable), invoice number and the invoice amount. Depending on the factoring company, you may send the original invoice to the factoring company and they will forward it to the customer; or you may a copy of the invoice to the factoring company and you send the original to the customer. 2. The factor verifies that your product was shipped or your service was performed. This is called verification. Verification is a valuable service that factoring companies perform to insure that the invoice is valid and that adequate documentation and authorizations are sent to the customer. Inaccurate or insufficient invoice documentation can delay or even prevent customer payments. 3. Upon successful verification, the factor purchases your new, or fresh invoices. The first funding will take longer because the factor has to establish your account; determine which customers to factor; and get familiar with the verification process for your invoices. 4. On first funding, the factor may also purchase your outstanding receivables (referred to as seasoned invoices). Factoring seasoned invoices will be determined by how much funding you need and the quality of the invoices. 5. The factor sends funds to your bank account, usually within 24 to 48 hours. Wire transfers can send the funds the same day. ACH transfers send the funds on the next day. Most factors pass on the nominal wire fee or ACH fee to you. The amount funded is the invoice amount less the reserve amount. If the factor charges a front-end fee then they will also deduct the factoring fee. 2

4 6. The factor collects the invoice payments and remits the associated reserve back to you. They may deduct chargebacks from the reserve. Chargebacks include bad debts, short payments, discounts or any additional factoring fees such as interest expense or wire transfer fees. This remaining reserve is called the rebate or available reserve. This reserve belongs to you. Below is a diagram which illustrates the factoring process and the flow of funds. Depending on the factoring company, the factoring fee can be assessed at either step 4 (as in the example) or at step 6. Step 3 is considered a front-end charge, while step 6 is a back-end charge. The example below shows a front-end charge of $30. 3

5 THE APPLICATION PROCESS You can qualify for factoring in as quickly as 2 to 3 days. Once approved, you can begin factoring your invoices within 5 to 10 days. Here is a guide to familiarize yourself with the application process. (Please note that every factor is a different.) 1. Submit all required documentation: The factor s application form. A report of your business s current A/R aging. A list of your customers addresses and phone numbers. Your business s most recent financial statements. Documentation that verifies your business s legal name. Example of a typical invoice. 2. The factor performs underwriting or due diligence: Checks company and owners background. Checks for accounts receivable UCC liens. Checks for tax liens and tax liabilities. Checks credit on your primary customers. 3. Sign the factoring agreement and documents The factoring company s agreement. A personal guarantee. A limited power of attorney. Notice of assignment. Required documentation is pretty straight-forward. The factor s application will have questions to determine your industry, size of receivables, business type, and creditworthiness of customers. Business type helps the factor determine what set of documents are required. Documents are slightly different for corporations and LLC s than they are for partnerships and sole proprietors. During underwriting, the factor will check for any UCC s filed under your company name. A UCC form is registered with the Secretary of State and 4

6 secures the collateral designated on the form. Collateral can be just the accounts receivable or all the assets of your company. A factoring company wants to be sure that no UCC exists on your company s assets. If a UCC exists, then it must be removed so that the factoring company can be in a first position. This requires contacting the owner of the UCC and requesting the removal of the UCC. You can discuss this with the factoring company. Once the underwriting process is complete, the necessary documents are signed. A personal guarantee helps put the factor in a more secure position. The power of attorney is usually limited in scope. It allows the factor to perform certain tasks to service your account. These include opening mail, endorsing checks, depositing checks and contacting customers. Upon preliminary or final approval, the factor will file a UCC to perfect its lien on your accounts receivable. NOTIFICATION Notification is the normal method of factoring. With notification factoring, the factor notifies your customers that you have sold your invoices to the factor and instructs your customers to remit payments directly to the factor. With non-notification factoring, the factor does not notify your customers that your invoices were sold. The payments are usually sent to a lock-box. This is also called confidential factoring. This is only used in certain situations where anonymity is required. RECOURSE FACTORING Recourse factoring is the normal method of factoring. With recourse factoring you are liable for any uncollected invoices, usually after 90 days. You have no protection from insolvency or unsettled claims by your customer. The factor can collect the unpaid invoices from you. 5

7 With modified recourse factoring, the factor insures the receivables with credit or trade insurance. This protects you from uncollected invoices if a customer can't pay for financial reasons such as bankruptcy or insolvency. With non-recourse factoring, the factor assumes all the risk of uncollected invoices for whatever reason. If your customer goes bankrupt or refuses to pay your invoice for any reason, you aren't liable for it. * Recourse factoring is normal because most risk is mitigated by the factoring company s credit services. If a customer risk is present, then the factoring company will advise you to avoid conducting business with the customer or they will secure the invoice with credit insurance. Usually, nonrecourse factoring is overkill and expensive. FACTORING RATES Factoring rates are typically 2% to 5% depending on the following: Monthly sales volume Number of invoices Your customers' credit FACTORING ADVANTAGES Financial benefits: Excellent for funding business growth or increasing working capital. Provides smoother and more predictable cash flow. Provides professional accounts receivable collections and management. Provides expert credit services, helping you avoid bad debts. Non-financial benefits: Provides invoice verification to insure payment. Protects small businesses from fraud due to internal control weaknesses. (i.e. Same person handling invoicing and collections) 6

8 Allows you to focus on your business, not collections. Reduces emotional stress and anxiety from lack of cash. CAN YOU FACTOR? It s much easier to qualify for factoring than a bank loan. If you have poor personal credit, then don t let that stop you from factoring. Factoring companies are more interested in your customers credit than your credit. Factors can work with almost any business that sells goods or services to other creditworthy businesses (B2B). Virtually any industry can qualify for factoring. Factors can work with start-ups or businesses with marginal profits. The only condition is that you maintain profitability. SHOULD YOU FACTOR? Businesses factor for many reasons. Start-ups need cash for working capital. Growing companies need cash to fund growth. The growth may be short or seasonal. Often the growth is sustained over long periods. Some companies need cash to get free of a cash flow crunch due to unexpected expenses. If you can answer Yes to any of these questions, then factoring is right for your business. Does the use of factoring generate a rate of return higher than the cost of factoring? Does the use of factoring generate a higher rate of return than other uses of your cash? If you need to pay down debts or liabilities, can you absorb factoring costs and remain profitable? 7

9 Contact Southwest Factors for all your factoring needs SouthwestFactors.com 8

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