This credit crisis has gotten everybody up in arms. It's caused banks to scale back significantly on who they loan to. In fact, the bailout money that banks received from the government was used to shore up the balance sheets of the banks instead of lending it to businesses. But it is not entirely the banks' fault. Businesses are afraid to expand or hire because they don't know what the government is going to do with respect to health care or other programs that could squeeze profits.
This causes a dilemma because businesses still have their operations to fund. Getting a bank loan has become a difficult proposition. There is a method of finance that is actually quite old but has become out of favor since credit had been easy to get (pre crisis). It is the ability for a business to get financing from its own accounts receivable. This sounds a little odd but it is both valid and legal. The concept is called factoring.
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As a part of doing business, many companies will extend credit to their customers. Receivables can be great from the perspective of getting sales but they leave the company in a bind. Receivables are often for thirty days out but the company needs to have cash to pay for operations today, tomorrow, and the next day, and everyday thereafter. That thirty day period puts the company in a cash shortage situation. When times were good, the company would contact a bank and ask for a short term loan. When credit was flowing banks were all to eager to provide this financing. Today though, credit is not so easy to come by, at least not from a bank.
So a factor can come to the rescue by advancing the company the face value of the receivable minus the fee that the factor would charge. This is often a win-win because the factor makes money through the fee and the company has access to the much needed cash. Unlike a bank the factor becomes the collection agent for the company and as such has his or her hand involved with the operations of the business. This is advantageous because the company can forgo the hiring of a credit department to handle this aspect of the business.
Now this is a very simplistic description of factoring. The factor will do credit checks on the customers of the client and there are other procedures that will need to take place. But when compared to getting a loan from a bank, the steps are usually much easier and faster access to cash is possible. What's great is if new sales are generated during this period those receivables can be factored as well.
When a business takes a loan from a bank, that generates a liability on the business' books. With factoring however, the receivable is an already an asset and there is no loan being generated. The factor is simply exchanging one asset (cash) for another (the invoice). So the financial position of the company isn't adversely affected because it took on more debt. Again, it's an exchange of assets.
Factoring is not for every company. In fact the fees are typically significantly higher than interest rates that banks would charge. But remember, a business would turn to a factor because it couldn't get financing from a bank. Further, the factor provides a service that would otherwise have to be handled by the company, i.e., collecting the money from the client's customer. In the end it can be a great arrangement.
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