Making sure you have enough working capital to handle payroll and stay current with your suppliers is a never-ending challenge for many types of businesses. Exploring alternative ways of financing, outside the traditional bank loan, can provide the needed funds.

One type of financing that has a long and respected history is factoring. Here is an overview of who they are, what they do, and the pros and cons of using this method of financing.

What Is a Factor?

In a nutshell, "factoring" is selling your accounts receivable to a third party, called a factor. The factor provides you with money upfront, then collects the amounts due on the invoices directly from your customers. The factor deducts his fee and forwards any remaining funds to you after the client pays him.

This is not a loan. You are using the money owed to you as the basis of the funding. The factor typically pays you 75 to 80% of the worth of your receivables and charges a fee of 2 to 6%.

Factoring has been around for centuries. In ancient times, traders in Mesopotamia used factoring to fund their shiploads of goods around the Mediterranean and in the Middle East. From the 14th Century, English clothing merchants relied on factoring to stay in business. It was an integral part of developing trade with the New World in the 1600s and beyond.

In the U.S., it has been a mainstay of the textile and automobile industries. In the 1970s, higher interest rates encouraged use of factors. In the 1990s, financial giants like GE Capital and GMAC entered the field.

In earlier decades, this was a service used principally by big corporations. Since the Internet has made the process easier, many small to mid-size business are using it.

Benefits and Drawbacks of Using a Factor

There are several benefits of using factoring to get money quickly. Here is a look at three.

1. Your credit score isn’t an issue. The factor is concerned about your customers’ ability to pay since that is where they collect their money. If your customers are deemed creditworthy, a factor will work with you even if you don’t meet the requirements for a bank loan.
2. It’s not a loan. This means your assets aren’t at risk, and you don’t have to worry about collateral.
3. Factors provide a range of useful services beyond funding. The factoring company performs the accounting work needed to collect your accounts receivable. They conduct credit checks for new customers and provide professional financial reports, so you know exactly where you stand.

However, there are downsides. Here are two of them.

1. This is a short-term solution. As a rule, most businesses use factoring in their financial strategy for two years or less. Factoring your accounts receivables can be useful as a source of quick cash to add to your working capital without having to increase your debt. However, it is not meant for the long-term.
2. It is more expensive than a bank loan.The fees charged by the factor are higher than most bank loans. However, if you don’t qualify for a loan, this is a moot point.

A money crunch can happen in any business. It might be due to unexpected expenses, a rapid growth cycle or the desire to take advantage of a one-time opportunity. If you have receivables, you can put that to work by using a factor as a funding source.

For more information on factoring or to search for a factor, visit the International Factoring Association (IFA) website. The IFA is an organization that provides resources for the factoring community.