This type of financing may suitable to some manufacturers as well as wholesalers. Typically, the seller of goods or services bills the customers for orders and then forwards these invoices to the Factors (the financing companies). In turn the Factors provide a pre-set percentage of the invoice, say 80% to 90% up front. The merchant receives money relatively in few days rather than waiting for customers to pay in 30 days or 45 days after the shipment.

Is that simple? NO, there is lot more than the simple illustration. First, the Factor must approve the customers. Then only 80% to 90% is advanced to the merchant. Second, the interest charges and the fees are generally much higher than the normal bank financing. Third, unless the factoring arrangement is based on non-recourse basis (see below), the merchant is always on the hook if the customers do not pay to the Factor.

The interest charges can be as much as 36% to 40%. Therefore, it is one of the most expensive type of financing a merchant would like to undertake. The eminent risk of default by a customer is always present when the merchant structures the deal based on recourse basis of financing. In such cases where the Factor assumes the ultimate responsibility of collecting the monies; the merchant is not held to pay back if the customers do not pay. In such a case, the fee and the interest charges are much higher.

Everything said above is a generalized scenario. When structuring a deal with the Factor, everything is negotiable. The starting point is the merchant’s credit strength. The type of business, the credit worthiness of its customers, the industry trends and other issues come into play.

So why anyone would go for this type of financing! Well for some, this type of arrangement still make sense, because of the short term nature of the financing. The finance charges of up to 36%, is not a major concern to some merchants, if the gross profit is higher and the customers are credit worthy. This type of financing is also useful for the cyclical nature of businesses and high ticket items.

For small and mid-size businesses (SMBs) where the normal bank financing is not available, the Factoring may be the only answer. If you must go this route, choose the Factor wisely and ensure that customers are credit worth.

Documents Needed: A good Accounts Receivable journal with aging report is a must. Also, prior year’s tax returns (if applicable) and the current financial statements would be required: