Factoring debate Pt1 - The X-factor

The press – the financial press in particular – is full of articles on the virtues of factoring. If you look at the writers of these supposedly ‘independent’ articles, however, they are invariably employees of factoring companies or banks which offer factoring facilities.

When I say ‘factoring’, I am referring to it in whatever guise it is dressed in – straightforward factoring, invoice discounting, cashflow finance or non-recourse financing. The objective of this article is to put forward the other side of the story – one very rarely heard.

Before continuing, I should say that while I am set firmly against factoring for the vast majority of small businesses, there are some industries (such as temping agencies) where I believe it is a useful tool if treated carefully.

The factoring companies’ sales people always have plenty of positive things to say on the subject. ‘You receive cash up front,’ they say, and this, of course, is true. ‘The facility is cheaper than bank funding,’ they continue. This is actually a short-term con. ‘Factoring will take away worries about credit control.’ In fact, customer relationships do not matter to them at the end of the day. ‘Factoring will provide bad debt insurance,’ they argue. This is sometimes offered as ‘non-recourse factoring’ by the factoring company embedding it in a deal. But if you unravel the charges it is usually very expensive.

What companies invariably forget to mention are the risks. So let me outline a few. One of two things typically happen when small companies factor their debt and the factoring company advances the first tranche of cash – and both result in the cash being lost in the business forever.

The first possibility is that when cash goes into the bank account, it eliminates the overdraft, leaving a small positive cash balance. The bank sees this and immediately cancels the overdraft facility, or at least brings it down to a far lower level. The second possibility is that the small company, stretched for cash (as all small companies invariably are), spends the money within six months. If the money is in the bank, it’s very hard not to spend it when creditors step up the pressure or the ‘bargain of a lifetime’ presents itself.

In either case, the money advanced is used up almost as soon as it is received. But business goes on, and the working capital requirement does not change. In the meantime, the company has ripped out its capital base.

The balance sheet now looks, and is, in a much worse state because the company has spent money which it does not actually have.

In addition, there is no incentive to pay off the factor. In my opinion, small companies who go the factoring route never get out of it. With a bank loan, there is a sensible and structured repayment plan incorporated into the loan. With an overdraft, there is the constant monitoring by the bank. With factoring, there are no incentives to clear the debt; on the contrary, the factoring company wants to lend as much money as possible.

The discipline required to create a positive bank balance sufficient to pay the factoring debt would be immense.

What is more, the factoring company often wants personal guarantees.

It may also withdraw the facility at the drop of a hat. Factoring contracts being cancelled without warning are not unheard of. Accounts being frozen, and new advances being refused, are common if the factoring company becomes even slightly nervous. This invariably has catastrophic consequences for the business, since no one else will lend money to a factored business.

Factoring charges are also very expensive. Small companies should always assume that if a deal looks too good to be true then it probably is just that. While in the short term the rates may seem good, small businesses should bear in mind that they will be factoring for many years to come, as opposed to taking out a loan and paying it off – hence no long-term charges.

Administration goes up, not down. The volume of paperwork, far from reducing, very quickly mounts up in an effort to keep sales ledger accounts reconciled.

The customer will need to supply the factors with copy invoices, proof of delivery, proof of artwork, customers paying the business rather than them, and so on.

Is the factoring company collecting the debts? If so, I would like to make two further points. Firstly, factoring is perceived by many customers, correctly in my opinion, as a last resort method of funding, and this will affect the business. Secondly, factoring companies do not care about clients’ customers. It does not matter how many times they say otherwise.

At the end of the day, the factor needs to collect and will not care if it upsets the customer.

Tight cash flow is a reality for all small and growing companies. If someone puts money into the bank account, it will be spent (or taken by the bank) unless the company’s owner is extremely disciplined.

Very few entrepreneurs or owners are. It is worth wondering why a bank might say ‘no’, to a loan secured on the business when a factoring company says, ‘yes’. Rest assured, a profit commensurate with the risk will be taken by the factoring firm.

I have seen many factoring contracts go badly wrong and I have rarely seen anyone extricate themselves from one.

Kall Kwik brings in a significant number of new centre owners every year and has 200 such centres throughout the country. My attitude and advice is always the same: don’t factor.

Troels Henriksen CA is joint managing director of Kall Kwik. Next week, Leslie Bland, managing director of Close Invoice Finance, will respond