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Factoring is the financial practice of borrowing against a business’ receivables. Factors give companies the ability to tap into capital by advancing on money owed to them. According to an article written by Liza Casabona for WWD, factoring dates “as far back as 4,000 years ago during the reign of Hammurabi, a Mesopotamian king,” however, the “industry’s rise and evolution in the U.S. is more easily traceable through its ties to the textile industry in the 19th and 20th centuries.” Since factoring has such a long history, statistics, probabilities and likelihoods of events happening are common knowledge in the industry. Further, the factoring industry is fraught with fraud and is risky business. Successful factors do their homework; doing background checks, making the calls and verifying the truthfulness of information provided by potential clients. This is done in an effort to calculate risk to determine who to work with and how.

When analyzing a prospective client a factor will hang his or her hat on the credit worthiness of the prospective client’s debtor. While reviewing a debtor list, a factor will check on credit limits extended to them along with their payment history. From a statistics perspective, if the client has a history of paying late (and therefore lower credit limits) the likelihood of them paying their future debts is slim. A factor can eliminate future problems with a client by eliminating those debtors with a poor credit history and a likelihood of defaulting on his or her debt to the client/factor.

With a decent client list to work from the factor takes a step back and digs a little deeper and will review the credit worthiness of the prospective client. The factor will consider the following points:
1. Is the debtor base solid over all?
2. What is the relationship with the prospective client’s vendors, and do they pay them on time?
3. What does their accounts receivable aging look like and what are their collection percentages.

The consideration of the noted points are based on probabilities the likelihood of “X” happening. For instance, if the debtor base is based on a list of weak debtors with one very strong one; what is the likelihood of the company surviving should they lose the business of the large debtor? If the prospective client pays his vendors slowly and or owes a large outstanding amount of money, especially if money is consistently owed to vendors over 90 days, how long will their vendors allow this to happen before cutting him or her off, thereby cutting off the prospective clients potential to continue running his or her business. Conversely while reviewing an AR aging; if a prospective client has customers who consistently are allowed to pay late or if the client is carrying invoices more than 90 days, what is the likelihood of the outstanding payments to be collected/paid.

Given the long history of factoring statistical analysis has shown 90 days is the magical number. When a prospective client fails to collect his or her outstanding receivables in 90 days or under, the likelihood of him or her collecting at all increases. If a prospective client does not pay his or her vendors in 90 days or under they begin to jeopardize their vendor relationships and put his or her company at risk of losing a manufacturing lifeline. Through careful financial analysis and the calculation of gross profit margin, inventory and AR turnover, a factor can mitigate their risk be assessing the likelihood of the company being able to make money using a factor. If the company has sufficient gross profit margin, their inventory turns quickly as a result of consistent sales, and they can collect in a timely manner, the likelihood of a successful client/factor relationship is good and will result in positive growth and profits for both parties.

Most business owners will tell you that it’s still pretty rough-going out there when it comes to obtaining financing. This is true despite improvements in the economy and efforts by the federal government to jump-start business lending among community banks.

In such a tight credit environment, the importance of the role played by asset-based lenders has increased exponentially. Asset-based lenders are vital in the economy right now and many small businesses don’t know where they would be right now without these specialty lenders.

The credit crunch has taken a difficult situation and made it impossible and many banks are referring clients to alternative lenders such as factoring.

Alternative Financing Solutions
Asset-based lenders provide creative business financing solutions for companies that don’t qualify for traditional bank loans and credit lines, whether this is due to their start-up nature, rapid growth, or financial ratios that don’t measure up to a bank’s requirements. These solutions typically include asset-based loans, accounts receivable financing and factoring.

In 2009, factors provided $140 billion in financing, up slightly from the year before, reports the Commercial Finance Association. And total outstanding asset-based loans increased 1.25 percent in the fourth quarter of 2009.

With bank underwriting guidelines getting tighter and tighter, the good news is asset-based lenders are able to plug a pretty big financing gap that exists right now: Businesses in need of critical working capital in this tough environment.

Manufacturers and distributors with creditworthy customers are often good candidates for asset-based loans and factoring because the financing is based on the credit quality of the receivables, not the net worth of the business owner or the historical profitability of the business.

Cash is king and factors are the way to convert receivables to cash fast! 

A Working Capital Boost
Asset-based lenders can also help companies that have bank loans or lines of credit but need additional short-term working capital to take advantage of opportunities, like an unexpected large order. Many banks are willing to allow a factor come in and share the credit risk of a client if it means keeping a good account.

Asset-based lending is often temporary, providing much-needed working capital during a start-up or transition phase until the company has enough financial history or a strong enough balance sheet to become “bankable” (bankable means three-to-five years of financial statements from potential borrowers).

Thus, factors and other asset-based lenders serve a clear need in the marketplace right now.  Many small businesses are taking advantage of these types of financing and are improving their cash flow greatly.

No doubt, obtaining a commercial loan is a difficult task. Most businesses took negative revenue hits the last couple of years; but, in large part businesses have weathered the storm. In this time of recessionary recovery some businesses expect to not just breakeven, but possibly realize a profit. Moving towards growth, businesses are beginning to visit banks in anticipation of financing pending developments. However, funding emerging growth trends will be a challenge without historical revenues and cash flow banks require.

Bankers are having difficulty finding customers that fit into the tight credit parameters for lending. However, savvy bankers understand that although many potential customers may not meet credit standards today, given a little time and maybe a little help, they might in the near future. Here’s the rub; customers want a complete package (the loan piece and depository relationship) and remain unwilling to move business over piecemeal. This situation is precisely where working with FSW can close the gap.

By providing a short term alternative loan solution, customers will be more willing to bring over deposits and move their entire banking relationship to the bank and banker who provides the introduction to the solution. Factoring provides growth capital, makes for a profitable company, along with motivating deposits.

It’s no secret that banks and bankers are hunting down deposits. Savvy bankers set themselves apart with a competitive edge; a FSW partnership is a leg up in providing loan alternatives to drive deposits.

This article is republished from CFOZone, where you’ll find news, analysis and professional networking tools for finance executives.

We hear a lot from small businesses about how hard it is to get a loan and a lot from bankers that demand from credit-worthy borrowers is down. Now a new study provides insights into the situation, by exploring the top reasons why banks are turning down applicants, along with plenty of other data. And because it includes asset-based lenders and other funding sources, it offers a wider view of just what’s going on in the financing landscape.

The study, from researchers at Pepperdine University, surveyed 1,430 borrowers, lenders and investors, looking at changes over the past six months. Since the most detailed analysis focused on banks and asset-based lenders, here’s a look at the most salient points:

Banks – Demand certainly does seem to be down, judging from responses from the 56 banks studied. About 11 percent reported an increase in applications over the past six months compared to 77.2 percent who had a decrease. But the quality of borrowers is up, according to 55.6 percent of those surveyed. That’s compared to 22 percent who reported a drop. And the number of approvals? That’s gone through the roof. About 76.5 percent reported an increase.
What are the reasons for turning down applicants? Top on the list is quality of cash flow. Almost 25 percent cited that as the reason. And 20.8 percent pointed to quality of earnings.

Asset-based lenders – The 52 asset-based lenders reported the mirror opposite, at least when it comes to demand. Sixty percent had an increase in applications vs. 8.7 percent who experienced a decline. Also while more lenders reported a drop in the credit quality of applicants, a majority saw an increase in the quality of borrowers who were approved.
As you might expect, the top reason for rejecting an application was insufficient collateral (30 percent). “In the weak economic environment, the valuation of collateral is going down,” John Paglia, an associate professor at Pepperdine and author of the study, said to me. Second on the list was quality of earnings (15.8 percent).

What’s it all mean? For one thing, asset-based lenders are attracting more interest from prospective borrowers, but the economy has done a number on their most important criteria, collateral. As for bankers, it seems they’re on the level when they say they want to make loans, but they can’t find suitable prospects.

Remember, if you are looking for a working capital line of credit contact Factors Southwest.

Credit is still tight for America's main stream small businesses. Even the Fed Chairman, Ben Bernanke, is concerned about the ongoing concern about "tight" credit markets. Read more...

To find out about alternative financing solutions, checkout www.factors-southwest.com

Let's examine the next of the 5 C's of credit - Capital.

CAPITAL (NET WORTH) refers to how much do the owners have invested in the company.

How much have the owners invested in the company?  
A bank may also be interested in how much capital has been invested by the owner, which requires calculated risk. 

• Financial statements and personal credit reports or statements assist bankers in knowing how much an owner’s personal resources can support the business as it is growing. 

• For companies that have yet to make a profit, elements such as an excellent customer list and payment history also come in to play.  Bottom line: the business should be perceived by a bank as solid.

Debt to Equity Ratio also known as Liabilities compared to Equity
Banks essentially are looking for sufficient equity in the company on the part of an owner. 
Sufficient equity can aide a business when times are soft. 

• It’s important a company be able to sustain itself during tough times. 

• Additionally, banks want assurance that an owner is truly invested in the company and will do what it takes to turn things around if cash flow becomes a problem. 

• When examining capital, banks typically analyze the company’s total liabilities compared to equity, or the Debt to Equity Ratio.  Most banks like to see the Debt to Equity Ratio no higher than 2 to 3 times.