First Person: What Is a 'Factoring' Loan?

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One of the toughest things for a small business to do, generally, is find financing when the company needs it. The joke always is that you can't get money when you need it, but when you don't need it, every banker wants to lend to you. I learned this a number of years ago when I decided to start my own small business, a computer printer service company.

Probably in my fourth year of business, one of my customers wanted to buy a large format printer; we used to call them plotters. It was going to cost us $1,000 that I didn't have free so for the first time, I resorted to factoring.

I admit that in addition to being grateful to get the money, I resented how expensive it was. In hopes of saving you the wasted energy on resentment, I want to share the pros and cons of factoring so you can go into it eyes wide open.

By the way, there are many businesses that use factoring on a regular basis and are thrilled with it. If you know what you are doing and have sufficient profit margins though inadequate capital to handle a surge in business, like the fashion manufacturing industry, then factoring may be the best source of money around.

Factoring Is Actually a Loan Against Your Accounts Receivable

First off, factoring is money loaned against your accounts receivable. Typically, a small business uses a factoring company, not a bank because they lack the cash reserves and, possibly, the credit necessary for a bank to make the loan. As a result, the loan will be more expensive than most bank loans. The plus side is that you may be able to get the money you need to make the sales when your less expensive options aren't available.

There are lots of things that affect both your interest rate and length of time before you must pay back the money with interest. Factoring companies like best businesses that have a regular pattern of selling receivables and that will sell them all of their receivables. Because this was a onetime thing for me, the interest rate was higher and the loan was for a shorter period of time, i.e. 90 days.

While I keep saying, "sell your receivables," this is truly a loan, not a sale. If the receivables you sell don't get paid within the term you agreed to, you must "buy back" those receivables. Depending on the factoring company you use, you may be able to substitute a different set of receivables or have to otherwise pay off the loan.

Pros

- Loan is based on the credit worthiness of the company owing you money as opposed to your credit score

- You can often get money for your business from a factoring company when you couldn't get it from a bank.

- You may be able to get the money faster from a factor than from a bank

- You get the cash to make your purchase that you are going to resell!

Cons

- Even though you "sell your receivables," it is really a loan so if your customer fails to pay you in time, you still owe the factoring company

- The interest rate tends to be higher than a bank loan. (I'm not sure, though, how it would compare to today's credit card rates.)

- You pay interest on 100% of the face value of your receivables despite only getting a portion of the loan. I got 75% of my receivables sold.

My Example as Recalled Ten Years Later

$1,000 x 24% = $240 in annual interest

Since your interest is actually for a 90 day loan, you only pay $60 in interest.

75% of $1,000 = $750 that you actually get to use

The point is that I paid something like $60 for a $750 loan for 90 days.

$60 / $750 = .08 rate for 90 days so .08 x 4 = .32 or 32% interest on an annual rate.

As I already mentioned, the good news - very good news - is that factoring enabled me to make a sale which allowed me to keep him as my customer. The other side of it is that the true cost of factoring is higher than it looks so it can be very risky on low profit product sales. If you consider the business case for factoring on each situation, you will find it a valuable tool in your financial toolbox.

*Note: This was written by a Yahoo! contributor. Do you have a story that you'd like to share? Sign up with the Yahoo! Contributor Network to start publishing your own finance articles.

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