Where are banks sending the borrowers they don't want anymore? To factors, where your credit is as good as your customers'
If you've recently gotten the boot from your bank, you're in good company. Consider John Yatsko, for example. His MPG Inc., a commercial printing company in Capitol Heights, Md., has enjoyed resounding success, leaping from sales of $1.3 million in 1988 to $3.3 million last year. But recently his bank refused to increase its modest line of credit to the company. Although it didn't tell Yatsko to get lost, its unwillingness to lend more forced him to seek other funding. He turned to the one type of financing that's still available and reasonably easy to get: factoring.
Factoring is a term that covers a broad range of services offered by a vast array of large and small organizations. In general, factoring involves selling your accounts receivable for instant cash. The commercial finance companies that buy accounts receivable are interested in how creditworthy your customers are, not your business's ability to pay back a loan. Thus, companies that can't cut it with a lending officer can often get money quite readily through factoring.
That makes factoring an attractive option for many start-ups in search of working capital. (See "Low-Brow Finance," May 1990, [Article link]) But it also means a lot to borrowers when bankers begin to show them the door. Unfortunately, there's a catch: it costs plenty -- much more than borrowing from a bank.
Factors nearly always look bad when their services are compared with banks' in this way. But now that banks have begun disappointing so many customers, factors are beginning to look more attractive. For Yatsko, selling accounts receivable to Allstate Financial Corp. provided cash at a crucial time. "We had gotten behind in taxes and also with some suppliers. It was a continual uphill struggle," he recalls.
By selling some $250,000 of accounts receivable a month to Allstate, a commercial finance company based in Arlington, Va., Yatsko has been able to catch up on his liabilities and repay most of MPG's bank loan. More important, he can take on all the new customers that have been knocking at the door. "Factoring is expensive, but what it does is put us in a position to double our volume," he says.
In fact, the best use of factoring is for fast-growing companies. In such cases, the problem is being able to pay for ever-larger orders of supplies and raw materials. By selling accounts receivable, a company can dramatically shorten the time it takes to turn inventory into cash, thus accelerating growth. Most of Allstate's clients, says Bret Kelly, senior vice-president of operations, "are positioned to do two to three times their current volume of business without increasing their overhead -- all they need is cash."
For companies that are making the switch from bank financing to factoring, however, strong growth prospects are essential. Because factoring is so much more expensive than borrowing, a company must be able to pay the higher charges by significantly increasing its volume or raising prices -- or both.
Yatsko's aim is to pump up volume. Here's how his arrangement with Allstate works. Let's say MPG types up $100,000 of the $250,000 in monthly accounts receivable that it has promised to sell to Allstate. The printer sends them over to the finance company, which does a credit check on MPG's customers and verifies that they actually received the printed materials MPG is billing them for. Assuming all's well there, Allstate wires MPG's bank $75,000 within 24 hours. That payment is based on a 75% advance rate.
If MPG is on top of its billing, that means the company can get paid for most of an order within a couple of days of producing it. That money can be plowed immediately into more material for new orders. MPG spends some $125,000 each month on paper. Now that Yatsko can buy it with cash instead of on credit, he pays 5% to 6% less.
The balance of the $100,000 is paid to MPG when the customer pays. Allstate's fee varies: If the bill is paid within 15 days, Allstate pockets $2,000, a 2% fee known as the discount rate, and forwards the remaining $23,000 to MPG within 24 hours. If the customer pays within 30 days, which is MPG's selling term, the rate ratchets up to 4%, or $4,000. The rate continues to grow by 2% for every 15-day period until the bill is 90 days old.
One of the advantages of factoring is that such geriatric invoices don't come along too often. Kelly says that Allstate's credit checking screens out bad-credit risks pretty thoroughly and that the company's collection staffers are on the phone, nagging customers, as soon as a bill is 37 to 40 days old. In theory, MPG benefits because Allstate's superior expertise allows fewer bad invoices through the hatch.
When one does slip in, Allstate ships it back to the company. That means it has what is called full recourse. Typically, a factor will ask its client to substitute a new invoice for a bum one. If that's not possible, Kelly says, Allstate will work out a plan to be repaid the amount out of previously submitted invoices.
For companies that desperately need the cash, the good news is that factoring can provide some relief. The bad news? "It's not meant as a long-term solution to financing needs," says Kelly. Most of his clients use factoring for just 12 to 18 months, until growth levels off and they find another financing source. So, ironically, while tightfisted bankers may be forcing you to go to factors today, chances are good that factoring will eventually drive you back to the banks.
How to decipher "factorese"
You won't hear anything about interest rates or covenants or account balances from a factor. These are the important terms and what they mean:
* Advance rate. This signifies how much cash a factor will give you immediately for your accounts receivable. Obviously, the higher the percentage the better. You can get as much as 80% if you have an excellent accounts-receivable history, with few bad debts or slow payers.
* Discount rate. This is the percentage of the invoice amount that a factor pockets for itself. It's determined by the volume of business you sell to the factor and how labor intensive and creditworthy your customers are. On one end of the spectrum, says Bret Kelly, Allstate Financial Corp.'s senior vice-president of operations, is a company factoring $1 million of monthly accounts receivable from the federal government, with an average size of $50,000. That's a no-brainer compared with a wholesaler that factors $50,000 worth per month from small boutiques scattered across the country.
* Recourse and nonrecourse. Factors that have recourse may send back any uncollected accounts receivable to you after they have reached a previously agreed-upon age. Factoring charges are much lower when you bear the bad-debt risk.