Because factoring tends to be used solely to finance the terms of payment extended by a business to its customers, brokers should become very familiar with this concept and why the granting of
terms of payment is so important (and often problematic) to small business.
In everyday business transactions, terms of payment are simply the conditions set forth regarding payment for delivered goods or services. When providing over-the-counter retail products or services, terms of payment are NOW, by immediate cash or credit card! In invoiced sales transactions between businesses (B2B), extended terms of payment are granted and will set forth the amount of time the customer has to remit payment for the goods or services purchased.
In B2B commerce, common terms of payment granted to buyers are 10, 15, or 30 days. In large international transactions, terms of payment can become much more complex and may include payment “conditions” such as trade documents processing or the posting of a trade or standby letter of credit guarantying timely payment to the seller. Terms of payment granted to customers may also feature discount offers for fast payment. For example, terms granted to a buyer of “two percent net 30” means the seller can discount the amount due upon the invoice by 2% of the balance if the payment is
remitted in less than 30 days.
There are many reasons for a small business to grant terms of payment to its customers. In some cases, it is simply because the customer is a large, creditworthy company that demands them. The small business will agree to grant terms of payment so it can receive the order. In other instances, extended payment terms are granted to keep existing customers happy and to maintain competitiveness in the marketplace. Attractive terms of payment can also be used to “woo” customers away from more established competition. But, no matter what the reason for granting terms, the result is always the same. The small business owner has suddenly found himself in the position of financier and is, in fact, financing a customer’s business by granting credit in the form of payment terms.
Unfortunately, by helping to finance the enterprises of customers, a business owner may also be creating a serious cash flow problem for his own company. All of those attractive payment terms granted to customers can suddenly add up and an owner may find himself chasing the checks of late paying customers just to make sure the cash is available for his own weekly employee payroll. For businesses with limited working capital, there are really only two ways to attack the terms of payment issue:
- Stop extending credit to customers (which may result
in losing existing customers and may cripple the ability to attract new ones). - Arrange for a method of financing accounts receivable.
Factoring, and several other forms of asset-based finance, are specifically designed to remedy such cash flow problems associated with invoiced sales. For smaller, non-bankable companies with a limited credit history, factoring is often the only readily available financing choice. That is because of how factoring is structured ,as a “purchase and sale” transaction, and not as a loan.
Almost everyone has heard of the term OPM or “other people’s money”. Factoring is a readily accessible cash flow solution for very young companies with minimal financial history because it operates on OPC or “other people’s credit”. Unlike a traditional bank loan where the bank looks at the borrower’s creditworthiness, with factoring, the business owner’s credit (or lack thereof) is of a secondary consideration. When underwriting a new client, the factor is much more interested in the credit history of the business owner’s customers, the ones who will actually be making payment on the purchased invoices, rather than the business owner himself.
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Invoice factoring, and the need for it, are related to providing liberal terms of payment to customers. If you want to comment on this article, why not provide a post on the IACFB Group on LinkedIn.