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Business Financing: What is Factoring?

Article | April 15, 2019

Factoring is an essential alternative to traditional bank financing. Here’s what you need to know.

Obtaining financing for your small business may be near impossible these days, at least when it comes to traditional bank lenders. Ever since the recession, banks were badly burned and won’t be forgetting that anytime soon. When the credit crisis erupted in 2008, banks began tightening their purse strings under severe financial pressures.

The major reason banks stopped lending to small business is because much stricter regulations were passed that raised the bar, preventing banks from taking the risk associated with small business loans. These new regulations along with the reluctance of banks to engage in high-risk lending stemming from the Great Recession.

When once banks were the #1 destination for businesses to obtain financing, now they’re incredibly stingy with their money to protect their bottom line and honor new regulations. One accessory manufacturer told that the “banks have gone from reckless to reclusive.” It’s understandable given the volatile nature of the lending atmosphere these days.

However, traditional banks aren’t your only options. There are many forms of financing – specifically the merchant cash advance concept which has become a viable source of funding and source of capital for many small businesses. While a merchant cash advance has historically been reserved for businesses whose revenue comes mostly from credit and debit card sales, such as restaurants or retail shops, this type of financing is now made readily available to other types of businesses that may not rely as heavily on credit or debit card sales.

In a nutshell, merchant cash advance providers will give you an upfront sum of cash in exchange for a percentage of your future sales. The merchant cash advance provider will deduct a portion of your credit or debit card sales until the agreed-upon amount has been repaid in full, explains Nerd Wallet.

Types of Financing

Traditional banks don’t provide alternative forms of financing but other types of underwriting and forms of collateral that can be utilized to your advantage. Here’s a peek at a few types:

  1. Purchase order financing: This is when you get money from a lender to
    support the development of your inventory for a specific order. It’s a very
    bold, aggressive and unique move.
  2. Accounts receivable financing: This is more common and can be used to
    support a line of credit or a loan.
  3.  Inventory financing: This can support existing inventory or the creation
    of additional inventory. IThis type of financing typically can be used for any
    purpose; it is simply collateralized by inventory.
  4. Factoring: Many industries depend on factoring to exist because it’s
    structured uniquely, different from other types of financing

A Deeper Look into Factoring

The most prominent example of an industry that relies heavily on factoring to exist and thrive is the clothing industry. The reason is apparent: due to the seasonality of clothes, manufacturers sell now for delivery a season away, such as selling in spring for winter delivery. As a result, those manufacturers don’t get paid till many months later. That’s why they factor their businesses.

  1. How does it work? Here are the steps: You ship the goods and want cash immediately.
  2. In a traditional scenario, you would have to wait for 30, 60, 90 or more days, which is not a viable way of operating your business.
  3. So, instead, you sell the receivable to a factor, who in turn gives you a percentage of the receivable, whether that’s 80 or 90 percent.
  4. They now own the receivable.
  5. You got paid slightly less than what it was worth, but at least you now have the cash to sustain your business through yet another season.

This creates immediate liquidity, providing the cash you need to continue to support your business. There is one caveat: even though the factor is buying the receivables and owns them, their customers have to pay the full amount back within a specified period, such as 45 days. If the customer fails to pay, the factor reserves the right to return the receivable to the company. Now, you’re in the hole for that cash and you’re liable for that receivable. You’ll have to repay the factor for it.

The factors operate by holding back a portion of the funds as a foundation to support bad debt. They have to protect themselves and their investments somehow. It may give you as a business less accessibility, but it works.

Many companies need factoring: the clothing industry to be sure, but also in the medical business world where providers frequently work with insurance companies.

In the merchant cash world, MCAs work like factors but don’t own the receivables. They’re lending against the debtors or the history of your receivables; however, they don’t own or collect them. You do that when you pay them.

Ultimately, factoring is an essential alternative to traditional bank financing in that it provides a valuable role in supporting a business’ access to resources.

Learn more about how Second Wind can help.

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