A Cash Stream Financial White Paper

Factoring 101

An Introduction to Factoring - The Basics You Need to Know

By Tim Lea

Cash Stream Financial

All Contents © Cash Stream Financial 2007-2009 Last revision 20 April 2009 2

Cash Stream Financial is a boutique independent commercial finance brokerage and advisory house. We specialize

in raising working capital finance – primarily factoring, invoice discounting, acquisition finance and inventory finance.

Our objectives are to provide SME’s and their advisers with best in class advice and guidance. You may be interested

to know that we have created a Learning Centre within our web-site, which includes a variety of short videos and

articles on various aspects of commercial finance – to help companies and their advisers make more informed

decisions. We have also created a suite of working capital calculators within our Tools section.

Should you have any queries or observations regarding this whitepaper or any other matter, please do not hesitate to

contact us on 1300 79 30 60 or email us.

About the author: Tim Lea has specialized in factoring for the past 20 years and is a published author on the subject

of factoring and invoice discounting. He is managing partner of Cash Stream Financial a commercial finance

brokerage with a specialism of raising working capital finance. You have full permission to reprint this article provided

this box is kept unchanged.

All Contents © Cash Stream Financial 2007-2009 [Factoring 101] 3

Table of Contents

Introduction ............................................................................................................ 4

The History of Factoring ........................................................................................ 5

How Does Factoring Work? .................................................................................. 6

The Facilities Available In the Marketplace .......................................................... 7

How Does Factoring Strategically Fit Into A Company’s Financing Plans?........ 8

How Does Factoring Compare To Other Forms Of Finance? ............................. 9

Factoring Versus the Bank Overdraft ................................................................. 10

Typical Signs That a Company Should Consider Factoring .............................. 11

Common Misconceptions about Factoring ......................................................... 12

Is Your Company Suitable to Factoring?............................................................ 13

Companies Not Suitable to Factoring ................................................................. 14

The Costs of Factoring ........................................................................................ 15

Cost Justifications for Factoring.......................................................................... 16

Key Issues That Will Affect Available Funds in a Factoring Facility .................. 17

Conclusion ........................................................................................................... 18

All Contents © Cash Stream Financial 2007-2009 Last revision 20 April 2009 4

Introduction

Many people have called factoring many things over the years, and to be honest some of

them not very complementary. In an attempt to remove the stigma that was associated

with “factoring” in its early days (mainly in the 70’s and 80’s) the factoring industry

world-wide has tried changing its name to Debtor Finance, Invoice Finance, Cash Flow

Finance, through to Receivables Finance and Invoice Discounting. Whatever name is

used it is essentially the provision of finance against the business to business invoices of a company.

In this whitepaper we will explore:

The basics of factoring

How it works

The different facilities available within the marketplace

How it compares to other forms of finance

The costs and their justification

The typical companies that use the facility. Some key things to look out for with the facility

The enclosed Whitepaper seeks to bring together 20 years of experience within the

industry - so we can only hope to skim the surface of a facility that that is gaining increased acceptance worldwide.

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The History of Factoring

Factoring has been around as long as civilization has carried out business. There is some

evidence dating back to the time of the Mesopotamians, where the essentials of a Factoring

contract were seen in their Cuneiforms, the stone tablets used for communication at these times –

over 3,000 years ago. Equally, there has been further evidence of Factoring in Roman times

where promissory notes – i.e. a promise to pay – were being sold at a discount to third parties.

Indeed the very name of Factoring takes its name from the Latin derivative of fattura (the Italian word for invoice).

Factoring facilities as we know it today were first developed in the early stages of international

trade in the 17th and 18

th Centuries, where the length of time between producing and shipping

raw materials meant a very long delay in payment being received. Early Merchant Bankers in

London sought to bridge this gap and also provided local knowledge about the ability of local buyers to pay for the product purchased.

It was the 1920’s that saw Factoring truly take off with the massive growth being seen in the US

textiles industry. The local banks at the time were very conservative lenders – seeing expansion

as a higher risk and as with all vacuums that are created this gap in the market was filled by

Factoring finance specialists. Even today the textile industry world-wide is an extensive user of Factoring services.

Factoring since this time has become an increasingly mainstream facility, with it becoming a

multi-billion $ business worldwide. Indeed Factoring is increasingly become recognized as the de facto finance facility for expanding companies.

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How Does Factoring Work?

Factoring is essentially very simple.

1) A company raises its invoices to its

customers in the usual

way, with Details of those invoices are sent

to the financier.

2) After assessing the

creditworthiness of

customers and the bona fides of invoices,

up to 90% of the

invoice value is

released - usually the same day. (This is

instead of a company

waiting for typically around 55 days to get

paid.)

3) The customer pays the

invoice to the financier directly

(disclosed Factoring)

or to a separate trust

account held in the company name but to

the order of the debtor

financier in the case of Invoice Discounting.

4) The financier then returns the remaining 10% of the invoice value funded upfront to the

company, less their charges of course. It is almost as if a company borrows its own money.

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The Facilities Available In the Marketplace

The various facilities available are dependent upon the risks of your business and the quality of the security being offered, i.e. the nature of your invoices.

The greater the perceived risk the more likely the facility will be on a disclosed basis – i.e. your

customers will be aware of the financier’s involvement – usually by means of a stamp on the

invoice saying the invoice should be paid directly to the debtor financier. In certain

circumstances, the Factoring company will also chase the customers directly on your behalf.

Now as risks reduce, primarily, but not exclusively, through good profitability, so confidential

facilities become more likely. Under these circumstances your customers would know nothing of

the financier’s involvement in the funding of your business, with the relationship being purely between the debtor financier and yourselves.

Within the marketplace there are various debtor financiers that will also look at combining the

funding other assets (e.g. property, inventory and plant and equipment in addition to your invoices/receivables – these are known as Asset Based Lenders)

All Contents © Cash Stream Financial 2007-2009 Last revision 20 April 2009 8

How Does Factoring Strategically Fit Into A Company’s Financing Plans?

Most small businesses go through a growth cycle, and there are different facilities for

different phases of that growth cycle. Typically a new start business will be started by the founder of the business putting their house up for security for a bank overdraft facility.

As the company expands, however, so there is a marked increased need for working

capital – to finance inventory, overheads, debtors etc. Disclosed Factoring comes into its

own at this stage of growth as Debtor financiers provide finance that grows directly in

line with the sales of the business and as a general rule do not require real estate security

– instead they look at the invoices of the business themselves as their primary source of

security. In other words when you raise an invoice you get cash immediately rather than waiting to get paid – and the more invoices you raise the more the cash you get.

Following this initial stage of growth many companies go through a period of

consolidation, where margins become the focal point of a business and weaker customers

are removed. At this stage of development usually fixed business loans are more relevant

to a business as compared to Factoring as the additional costs associated with Factoring

do not easily cost justify themselves (e.g. the increased costs cannot be offset by the additional gross margin generated through the increased growth of sales).

After a period of consolidation companies typically go through a second growth phase

but this time with stronger financial and operational systems in place. Usually, companies

can handle their own debtor collections and have good reporting systems in place - so invoice discounting, the confidential version of Factoring, becomes the facility of choice.

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How Does Factoring Compare To Other Forms Of Finance?

Any expanding company needs additional working capital – to finance inventory, wages,

overheads etc and the faster the growth, the more working capital is required. So what are the other financing options to consider?

You own equity – maybe you have savings or you could ask your family or friends. The

question is do you want to use your own money or that of those people close to you? What if

it all goes wrong? This is perhaps even more appropriate given the current uncertain

economic conditions and the credit crunch.

You could look at external equity – but this means giving up a percentage of your business –

is that what you want? Equally because the stock markets world-wide are weak, property

prices are at best sluggish together with extensive weaknesses within the world economy,

cash is the safest haven currently. So any external investor is going to want greater rewards

for taking the risk of investment in your business - all at your expense.

You could offer additional security to the bank to increase your overdraft – do you have any

additional security to offer? Do you want to put it up? Again what happens if it all goes wrong?

All the above financing options are equally valid – with it dependent upon your own risk appetite

and the profile of your own business and your own assets, together with your desire to maintain control of your business.

In the current economic climate it is certainly worth giving some consideration to Factoring in its various guises, as it does have a valid part to play if you are in an expansionary phase:

No real estate will be directly under threat as the factors do not generally take real estate as

security.

No equity needs to be offered to third parties – you maintain 100% control of your business.

You are using your business assets to fund your business expansion not personal assets. The facility grows in line with your sales success.

(Just as a side note given the current economic climate – bear in mind it is also easier (and cheaper) to raise debt when you are not desperate for it.)

All Contents © Cash Stream Financial 2007-2009 Last revision 20 April 2009 10

Factoring Versus the Bank Overdraft

Bank overdrafts are by their very nature fixed in nature, usually secured against a fixed

asset – usually real estate. But growing companies need additional capital. So if you are

an expanding company you might notice your bank overdraft limit gets hit regularly, and

you get those phone calls from the bank manager asking you to deposit additional funds.

Often there is a core level of borrowing being seen, usually very close to your overdraft limit.

With Factoring on the other hand as soon as you raise your invoices you can get cash - up

to 90% of the face value of the invoices, usually within 24 hours. So the more you sell the

more your finance facility grows with you. (Of course the opposite also occurs if your

sales fall – so a little caution is sometimes required – it is usually best practice to have some form of working overdraft facility just in case sales take an unexpected downturn).

The beauty of Factoring versus an overdraft is that

You do not generally have to put up real estate security to get the facility (although a

personal guarantee will be required - mainly to cover fraud).

Funding is against your current sales performance not against your historic balance sheet

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Typical Signs That a Company Should Consider Factoring

In almost 20 years involvement within the Factoring industry I have seen the facility work

incredibly well – especially for those that are in an expansionary phase. Over that time the

enclosed comments are typical of companies that could benefit from Factoring. Whilst far from

exhaustive, if any of the enclosed comments reflect your position, you should at the very least consider Factoring as an option.

If only my customers would pay me quicker ……...I could …….

My overdraft is so restrictive…….

If I had more cash I could really grow this business......

I’m having to turn away new business......

My suppliers are restricting my growth......

My partner hates us having our house as security for the overdraft........

I lost money last year, but have turned the corner…..and need cash to grow

All Contents © Cash Stream Financial 2007-2009 Last revision 20 April 2009 12

Common Misconceptions about Factoring

There are many misconceptions of Factoring. We have detailed the three key ones we have heard regularly over the past 20 years of being involved in the industry.

Misconception 1. Factoring Companies give you 80% of an invoice and keep the rest.

The truth is Factoring Companies can advance up to 90% against an invoice, returning the

remaining 10% when the customer pays the invoice (to the factor). In reality you will pay a

service fee of between 0.1% - 2.5% against an invoice value, plus the cost of the funds on the volume of funds you choose to borrow.

Misconception 2. Factoring is for companies that are going bust. In general business

life, there are as many companies going bust on the way up as on the way down. If your

business is expanding the facility is ideal as the finance grows directly with your sales. If

your company is failing, however, the additional cash will only put off the inevitable if the

monies are used unwisely. In general terms Factoring companies do not want to get

involved with failing companies – as they have to realize their own security if your

company ceases to trade. This presents marked risk for them – after all in an insolvency

disputes typically come out of the woodwork because customers recognize they will not be

dealing with you again. That said, Factoring companies are generally also very commercial

in their approach and can support companies that are in “turnaround” - Providing they

believe in the business, the management and its plan of action – and yes sometimes turnarounds do not succeed – but factors can venture where banks fear to tread.

Misconception 3. If my customers know I am using Factoring they will change

supplier. If you have a disclosed Factoring facility, the dealings between the Factoring

company and your customer will usually be on the purchase ledger side of their business –

i.e. one accounts department talking to another. Equally what other way to say you are

growing and being successful than a finance company openly declaring they are supporting you.

In reality, however, there are some of your customers who do not like dealing with

Factoring companies – and it’s often those that don’t pay you on time! It is harder for them

to upset you by paying late because now they are not just upsetting you as a small business,

it could affect their overall credit rating because they are dealing with a larger finance institution.

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Is Your Company Suitable to Factoring?

If you remember one thing from this whitepaper it would be this – any company whose product

or service is BUY.....SELL ......FORGET is appropriate for Factoring. So, for example, take a

simple product – the coffee cup on your desk. It is very simple to manufacture and very few go

wrong. Sure the handle might come flying off but in general terms the cups would be bought in

from a supplier, sold and forgotten about. If you take the other extreme, however, – the

Construction sector – where companies have complex contracts, with stage payments, interim

valuations, liquidated damages and a potential dispute around every corner – it’s all very messy – in other words not buy, sell, forget.

The typical companies that use Factoring are detailed below :

Recruitment – Factoring companies will advance up to 90% against temporary contractor

invoices (usually up to 60% against permanent placement invoices)

Wholesalers - factors will typically advance up to 85% against wholesalers’ invoices.

Certain Factoring companies will also look at financing inventory in tandem with your

receivables if you are a wholesaler

Import/Distribution – Factoring companies will typically advance up to 85% against

importers’ invoices. Certain Factoring companies will also look at financing inventory in

tandem with your receivables if you are an importer – and may even use the receivables

as the security to help fund a letter of credit to your overseas suppliers.

Printing - Factoring companies will typically advance up to 85% against Printing

Invoices.

Transport - Factoring companies will typically advance up to 85% against Transport Invoices.

The above list is far from exhaustive, and if you have any doubts about whether your business is

suitable just get in touch with a specialist factoring broker, like ourselves at Cash Stream Financial.

All Contents © Cash Stream Financial 2007-2009 Last revision 20 April 2009 14

Companies Not Suitable to Factoring

Unfortunately not all companies are suitable for Factoring. Remember we mentioned

earlier the concept of BUY SELL FORGET. The further your business is removed from

BUY SELL FORGET the less likely factoring will be available to you. For example:

Construction – very contractual – stage payments, Liquidated Damages

Professional services – e.g. accountants – where there is extensive interim billing and

ongoing projects.

Bespoke Computer software – usually this involves stage payments and is part of a

larger contract

Large ticket manufacturers – e.g. conveyor belts for mining – typically large stage payments are involved

Some independent factoring companies can look at these traditionally difficult sectors –

but the transaction needs to be structured carefully. Usually their offerings will mean the

level of finance available is usually significantly reduced, the costs can be higher and

additional security may be required. If in doubt speak to a specialist factoring broker like ourselves at Cash Stream Financial.

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The Costs of Factoring

The Costs of the facility are generally more expensive than traditional bank overdraft facilities.

The key benefit to you is that you get access to more cash than a bank would feel comfortable

giving you. Banks might look towards funding a business at 30% - 50% against a receivables

ledger (if they consider it at all) but because factoring companies are specialists they can advance more (up to 90%).

Costs are usually broken down into 2 areas:

A service fee expressed as a % of turnover – usually of the range 0.1% - 2.5% of invoice

value. In a number of cases a fixed annual management fee can be negotiated.

The Cost of the funds you choose to borrow – these are usually in line with overdraft

facilities not secured by property.

(There are an increasing number of factoring companies who are offering credit insurance as part of their facilities, reflective of the current economic conditions)

In general the costs are dependent upon the facility chosen, the risks of your business and your

level of sales.

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Cost Justifications for Factoring

Factoring is a more expensive form of finance than traditional overdrafts. However, it is

the added value it can bring to your business that makes it a worthwhile facility to

consider:

If the facility gives you access to additional cash flow to expand your business – e.g.

through purchasing more inventory – then consider the additional sales you can now

make. Clearly with those additional sales there will be additional gross profit.

With additional sales, you will have additional purchases from your suppliers – so there

will be potential for additional volume discounts.

The facility gives you access to additional cash flow so consider asking for early payment

discounts from your suppliers – for example instead of paying them in 60 days you may

pay in 30 days – so ask them for a discount. In the current uncertain economic

environment – especially, many will be very happy to give probably quite a substantial

discount.

If you use a full service factoring facility – where the factor chases your customers - there

are direct costs of receivables management can be saved.

Be aware, however, that there is some administration required to run a factoring facility.

Whilst most factoring companies will use and rely upon technology to reduce these costs,

these costs need to be taken into account.

Whilst very simplistic in its nature the enclosed will give you a rough indication of the

cost justification of factoring (excluding any overhead costs):

Additional Annual

Gross Profit

Generated Through

Additional Sales

+ Additional Supplier

Discounts

Generated (Volume

And Early

Payment)

- Direct Costs of

Factoring (Annual

Service Fee +

Expected Costs Of

Borrowing

= Cost Justification

(You might be interested to know in our web-site we have created a cost benefit

calculator for factoring and invoice discounting. Just visit our Tools Section)

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Key Issues That Will Affect Available Funds in a Factoring Facility

Factoring is a great facility but like anything there are the day to day “wrinkles” of running a

facility. Because we are trying to summarise 20 years experience and to keep the document

within a manageable size to read, we can only look at some of the major issues that will affect

the level of funding made available to you when considering a factoring facility. For further

guidance and advice speak to a specialist factoring broker (such as Cash Stream Financial).

Please understand your receivables will change on a day by day basis – and as a result so will

the factor’s security. Your funding will also change as the following issues are brought into play:

Spread of your customers – if you have a customer that represents, or will represent,

more than 25% of your receivables – ensure you speak with your factoring company.

Many factoring companies impose a spread restriction (sometimes called a concentration

limit – usually around 25%-30%) on your outstanding receivables. They will NOT fund

a customer beyond this spread restriction. For example assume your Receivables are $1m

and your major customer is $500k (i.e. 50% or your receivables). If your factoring

company has a spread restriction of 20% – the maximum level of invoices the factor

would fund against a major customer is $200k (i.e. 20%*$1m). In other words $300k of

your major customer’s invoices would NOT be funded. (i.e. The outstanding balance

$500k less the restriction limit.)

Credit Notes – look at the levels of credit notes you raise. Factoring companies don’t

like to see high levels of credit notes – as this implies the products or services you supply

are not of “merchantable” quality, if returns are being seen. In general terms double the

level of credit notes you produce and deduct that from 85% to get an approximation of

the level of funding a factoring company will give you.

Contra Accounts/Reciprocal trading – check your aged payables – if a customer is also a

supplier the factoring company will not fund this customer (they MAY consider some

funding if the balance on the aged payables is small). This is especially true within the

transport industry where “back-loading” is prevalent.

Over 90 day accounts on your Receivables – “an old debt is a cold debt” is the age-old

adage – and if the factoring company sees a high level of over 90 day debt it makes them

concerned that the debts are either disputed or the customer is of questionable credit-

worthiness. The factoring company will hold all balances over 90 days past the due date

(some do it after 60 days past due)

Credit worthiness of your customers – if your major customers are of questionable

credit quality, the factors may restrict the level of funds they advance – after all how

would they get their money back if your customer failed. Some factoring companies do

offer credit insurance policies as part of their facility offering (at increased cost).

As highlighted above we have only touched on the ways in which the factoring companies assess

your business. Each factoring company will be different in the way they handle these issues. As a

general rule the independent factors generally have more flexibility (although the credit crunch is

affecting even their ability to be as flexible as they once were)

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Conclusion

In this whitepaper we have just focused upon the introductory aspects of factoring. The facility

has the power to help you expand your business, without needing to put up real estate security

and without giving up equity in your business. Whilst the facility is more expensive than

traditional bank overdrafts, its flexibility for companies in a growth phase is marked, enabling

the your finance to grow directly in line with your sales.

I have seen the facility work so well for so many companies over the 20 years or so that I have

been involved in the marketplace. I have also seen it work for companies in turnaround – where

factoring companies give the owners of businesses the opportunity, time and cash flow to

overcome difficulties that they may have experienced. They take the time and trouble to analyse

and support a position traditional bankers unfortunately find hard to do.

Do companies go bust using factoring? Sure they do – but companies also go bust without using

factoring. If the facility is used well it can help speed up the growth of a company. Like any form

of finance if it is used badly it can do just the reverse. Factoring gives you the potential to speed

up your business growth whilst offering the opportunity to safeguard your personal assets.

I hope you can use it to make your business more successful.

Tim Lea

Partner,

Cash Stream Financial

tim.lea@cashstream.com.au

www.cashstream.com.au