The smaller business often struggles to obtain bank loans for a variety of reasons, which is why the notion of ‘factoring’ has become popular, as this is a financial transaction whereby a business sells its accounts receivable – or invoices – to a third party at a discount.
What is Factoring?
Differing from a normal bank loan in three ways:
- Factoring places the emphasis on the value of the receivables, rather than the firm’s creditworthiness.
- It is not a loan, but rather the purchase of an asset.
- Whereas a bank loan involves two parties, factoring involves three – the seller, the debtor, and the factor.
“Effectively what happens with factoring is that the seller is owed money – generally usually for work performed or goods sold – by the second party, the debtor. The seller then sells one or more of its invoices at a discount to the third party (the factor) to obtain cash, while the debtor then directly pays the factor the full value of the invoice,” says Kugan Pillay, Head of Debtor Finance at First National Bank.
“This enables the company selling its invoices to obtain cash in hand that it can then use to bolster its own growth, while at the same time no longer having to worry about collecting from the debtor – in a sense you could almost call it an outsourced debtors function.”
He says that factoring unlocks more capital than a standard bank loan, in essence making factoring an overdraft on steroids.
“There are many benefits to factoring, such as the instant cash injection one gets for your business, while you also don’t require a significant balance sheet in order to borrow money, because it is based mainly on the creditworthiness of the debtor, and to a lesser extent on the strength of your company.
“In addition, it brings administrative support and credit control to your business, and the instant cash injection is a growth enabler for smaller businesses,” says Pillay.
He points out that the negative aspects are more perceptions than reality, as it is often viewed as being highly admin-intensive, and that there also tends to be a stigma attached to factoring.
“There is a school of thought that suggests that if you’re doing this you’re borrowing from a lender of last resort, but this is largely a local view; internationally factoring is often the first port of call rather than the last resort.
“The important thing is that this attitude is changing, because, as more businesses realise the way factoring can enable your company to grow rapidly, more people are turning to it as a means to generate cash for the business,” concludes Pillay.