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What makes an ideal factoring candidate? Is factoring right for my business?

What makes an ideal factoring candidate?

ideal factoring candidate

 

Ideal Factoring Candidate

Table of Contents

  1. What is factoring?
  2. How can invoice factoring help your cash flow?
  3. An ideal factoring candidate
    1. Account debtor creditworthiness
    2. Terms of sale & invoice collectability
    3. Competing security interests
    4. Invoice verification
    5. Concentration
    6. Operational compatibility
1. WHAT IS INVOICE FACTORING?

Invoice factoring is an effective form of business financing. Rather than waiting 60, 90, or 120 days for invoices to be paid, a factoring company will purchase your outstanding invoices and pay them in as little as 24 hours. Cash now, for invoices due in the future means your company can use the cash to cover business expenses.

Let’s consider some cash flow challenges. Do any of these situations sound familiar?

  • Have you offered your customers credit terms, which means they pay up to 90 days after an invoice has been issued?
  • Has the bank said NO to your business loan?
  • How about your line of credit? Is it at capacity?
  • Is your cash flow becoming a constant challenge?
  • Have you recently increased capital expenditure, negatively affecting your cash flow?
  • Is your business credit too low to qualify for a traditional business loan?
  • Do you need to improve your cash flow in order to grow?
  • Does your company struggle to meet payroll?

Late payments can quickly cripple cash flow and bring a small or medium business to its knees. If these challenges sound familiar to you, invoice factoring could be the key to getting your cash flowing.

2. How can invoice factoring help your cash flow?
  • Quick Qualification

Unlike a bank loan, the qualification process for invoice factoring only requires basic company information and can be completed in as little as 3 days, once the application is accepted.

  • Fast Cash

No more waiting on slow-paying clients. The factor will typically pay you within 24 hours after receiving your invoices. No more waiting for 30,60 or 90 days.

  • Use your own receivables as cash

Because you are using your own receivables, factoring will not show up on your balance sheet.

  • Imperfect Financial Statements

Qualification for factoring is based on the creditworthiness of your customers, not your credit.

  • Accounts receivable managed by experts

The Factor’s professional A/R team manages the receivables that you factor, saving you time and A/R management expenses.

  • Reduce the stress of constrained cash flow

Factoring your invoices and getting immediate cash reduces the stress of late payment, and the inability to pay taxes or meet payroll.

Waiting for customers to pay their invoices may be a large contributor to your company’s cash flow crunch. Invoice factoring offers fast payment of your invoices, which can help avoid this situation.

3. An ideal factoring candidate

Factoring is available to perhaps the widest category of businesses today. With the wide availability of factoring and the various industries it serves, qualification for factoring has changed very little. Because of advancements in communications and therefore information, never before has a factor been more secure.

Ideal factoring candidate- No two factors will have similar underwriting parameters when evaluating a potential factoring client. Some factors utilize similar underwriting guidelines as a cash-flow lender, others simply utilize a collateral model and some employ a combination of both. Regardless of how they determine eligibility for a factoring facility, they all look at six primary qualifications:

  • Account debtor creditworthiness
  • Terms of sale & invoice collectability
  • Competing security interests
  • Invoice verification
  • Concentration
  • Operational compatibility

Let’s examine each preliminary qualification for an ideal factoring candidate in detail:

(a) Account debtor creditworthiness

This is a fundamental question that must be answered. A factor will determine the amount of credit that can be extended to an account debtor based on information the factor receives from an independent third party such as Dunn & Bradstreet. Upon receipt of the prospect accounts receivable ageing report, a factor will determine if the amount open to an account debtor would be eligible for purchase.

Microsoft is considered a highly creditworthy entity. If a prospective factoring candidate was selling Microsoft $100,000 worth of products, few factors would have any reservations about buying these invoices. If the prospect was selling to other less known companies in similar amounts, the credit extended would be scrutinized.

Often times a factor works with a prospect that has very limited or no credit policies and procedures in place. The net effect is a prospect that is blindly extending credit without being aware of the potential risk involved.

Many prospects base credit decisions on collection histories with individual customers which can be one of the worst qualification parameters in credit extension. Once a credit determination has been made, a factor will have a reasonable idea of the amount of credit they can extend each account debtor which will total a certain percentage of the prospect’s total outstanding accounts receivables. The higher this percentage is to the total outstanding receivables balance, the greater effect factoring will have on the business.

(b) Terms of Sale & Invoice Collectability

A factor must determine if the goods or services provided have been completed and/or delivered and accepted by the account debtor. The invoices must represent a legally sustainable debt based on certain performance by the factoring prospect.

There are five common forms of sale:

  • Straight Sale. A straight sale is where the account debtor has no rights (outside of legitimate disputes or offsets) to return the merchandise or withhold payment.
  • Guaranteed Sale: An account debtor has the right to withhold payment until a certain milestone has been met in which payment will be released to the supplier. Generally, factors will not advance on this type of sale.
  • Consignment Sale: An account debtor will only pay for what has actually been sold. Generally, factors will not advance on this type of sale.
  • Bill and Hold: A prospect has sent an invoice to an account debtor without shipping goods. This is usually based on an agreement between the prospect and the account debtor. Generally, factors will not advance on this type of sale.
  • Billing in Advance: A prospect is billing for goods or services before any consideration has been made. Generally, factors will not advance on this type of sale.

Terms of sale should be properly supported in any documentation which is commonly referred to as the “audit trail.” An audit trail is an information that supports the validity of the sale and ultimately the invoice. This may be a contract, purchase order, bill of lading, proof of delivery, time-sheet, draw request, etc. The audit trail should explain where the account debtor is obligated to pay the factoring prospect upon such time that goods or services have been delivered and accepted.

Normal terms

As a normal course of business, terms range from net 30 to net 90 days and are generally determined by a specific industry. For example, it is common in the apparel, textile and retail industries that net 60 days are standard terms. In temporary staffing, it is common to see terms from upon receipt to net 7 days. Circumstances may arise in which a factor will consider extended terms such as net 120 days. Factors are careful to evaluate terms of sale as they desire to be repaid as soon as possible. Getting paid in a more timely fashion increases yield and reduces risk.

(c) Competing Security Interests

A factor will immediately need to identify if there are any other secured creditors. Factors must have at a minimum a priority position on all accounts receivables. If a client has a bank loan or other obligation, a factor will need to determine if there is enough in eligible accounts receivable to retire the obligation which will give a factor a priority position.

(d) Verification

A factor will need to determine a method of verifying the validity of each invoice it purchases. Factors today employ three methods of verification.

  • Review of support documents;
  • Verbal verification with the account debtors payables department;
  • Written no-offsets verification which must be signed by the account debtor(s) guarantying payment.

Many factors rely on a combination of support documents, verbal verification or written no-offset prior to the purchase of an invoice. Factors must determine a course of action for each client which will provide adequate internal verification requirements. Consideration must also be given to ensure this process is timely to meet client funding expectations.

(e) Concentration

Factors are generally concerned with a prospective client’s overall concentration percentage. Concentration refers to the overall amount of credit extended to an individual account debtor. The higher the concentration, the more exposed the factor becomes. As a general rule, most factors prefer concentration limits that do not exceed 20 per cent.

(f) Operational Compatibility

Factors have varying appetites for clientele. For instance, some factors may have an industry niche such as third-party medical billing and sub-contractors. These niches are not shared by a very large majority of the factoring industry. Other factors may have transaction size parameters. It is important for a factor to determine early if they and the prospect are operationally compatible. 

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