Construction Factoring and Accounts Receivable Financing

      A growing cabinet business has run into cash flow problems, and is considering working with a "factoring" outfit. Fellow businessmen advise the owner to think twice. November 19, 2005

Question
I would like to know about your experiences with factoring/account receivable companies. I am in need of their services and have done quite a bit of research online, so I understand the concepts involved and processes in establishing a relationship with one. Has anyone used this type of service?

I own a cabinet design, sales, and installation company in the southeast. I design kitchens on the 20/20 platform, order cabinets from a manufacturer, and have my guys install them. 90% of my business is new home builders. I've been in business 3 years and have doubled my gross sales each year. I did 180K in year one, 380K last year and am on track to do 600K+ this year. However, with growth, I have problems with cash flow. I have reached credit limits with my current supplier (using another is not an option at the moment), I have shortened receivable timeframes to 2-3 weeks after installation (builders are at shortest limit), and all usable cash is being stretched to the limit. I'm at the point where my business is finally generating good profitability, sales are great, relationships are strong, good employees, etc. Any thoughts?

Forum Responses
(Business and Management Forum)
From contributor T:
It seems that if your supplier wants to expand their business with you, they may need to be more flexible with your credit limits. If you cannot work anything out with them, you should look into a second supplier. As you grow, providing your clients more options will become more important anyway, plus you have the added benefit of balancing cash flow.



From contributor F:
Take it from me, it is never good to put all your eggs in one basket. If you have to adjust your payment terms, do so.


From contributor J:
As someone who has sold factoring for many years and who has used their services, let me suggest that you thoroughly read and understand their contract. For instance, many don't realize that you are actually pledging all of your A/R, not just one or two invoices. (I don't care what the sales guys said.) Secondly, they may give you a pretty good advance rate and may even give you a decent short term rate (less than 15 days), but the rates jump significantly on day 16. No exceptions! Also, most construction factors (there are only 3 nationwide) contract that they can switch from non-paying customers to good paying customers so that they can protect their investment. What that means is that they will not absorb a bad debt, you will! Factoring can be a great bridge to get you over a hump, but don't rely on it for more than a few months. You see, companies who require factoring are in trouble. All factoring does is speed up your demise. I know this. Trust me.


From contributor A:
Your margins don't support your growth rate for "sustainable growth". Get someone to help you with a true cash flow projection for a year. You need either more deposits, quicker payment from your customers, and/or slower payment terms to vendors, and/or a bank line of credit. Banks loan on cash flow and it sounds like none of yours is sticking because you are plowing profits into expansion. If you are profitable and your profits are going into expansion, you should be able to find a bank.

If you slow your growth to 10% or so, then after 6-12 months you should be sitting on cash. A cash flow projection will show you how much you can grow each year. I would be very reluctant to use a factoring firm; you should be able to find a bank that would loan against a contract.

Many construction contracts are not assignable, so you may not be able to use factoring.



From contributor J:
It's true that many construction contracts aren't assignable. Also, your creditworthiness has nothing to do with a factoring arrangement. Instead, the factor will be looking to the creditworthiness of your customers. Likewise, your clients may not want to sign a paper stating that they owe you "x" amount of money. If they did that, then they would lose some leverage over you and they would become indebted to a factor who can be very relentless with their collection efforts. In other words, factors can and will alienate your clients if they are slow pays. I promise you that! Oh, and you can forget a factor covering your retention clauses. Stay away from factors!


From contributor M:
Many of the large cabinet manufacturing companies provide a service similar to factoring. I once nailed down a cabinet sale for about 100 townhouses and the company providing the cabinets offered a plan where they collected the money for a predetermined percentage rate, allowing me to order as many units as needed to keep up with demand. Didn't have a full term contract for the duration of the 100 units and was beat out by a competitor after the first 20 units and lost out on the 80 units remaining. I would agree with the posts above suggesting a bank line, as they have no interest in your customer, or letting it be known that they are in the picture. Some of your best customers may be slow to pay on occasion and should not be exposed to a collection agency.


From contributor S:
You should be able to finance your growth. Perhaps more is not better and you are not as profitable as you think. Your vendors should up your limits, if they feel you are a good risk.

That said, I do not believe factoring is viable for a truly profitable company. Think twice before using what sounds like a last ditch effort to finance your customers.



From contributor D:
Getting a call or a fax from a factoring company generally sets off bells and whistles with the general contractors. I would search for another solution. Possibly a short term bank loan with your contracts as collateral.


The comments below were added after this Forum discussion was archived as a Knowledge Base article (add your comment).

Comment from contributor C:
“As someone who has sold factoring for many years and who has used their services, let me suggest that you thoroughly read and understand their contract.” This is why you need a factoring consultant instead of a factoring broker. A factoring consultant acts on behalf of the construction company, not the factoring company. A good factoring consultant provides the client with expert analysis of an agreement and works to protect the construction company when negotiating terms.

"For instance, many don't realize that you are actually pledging all of your A/R, not just one or two invoices. (I don't care what the sales guys said.)" Not true. Whether a construction company enters into a factoring agreement or an accounts receivable factoring agreement with a third party factor, complete control is always in the hands of the construction company. Only the invoices submitted by the construction company can be purchased or applied to the credit facility in the case of an accounts receivable factoring agreement.

The factor can only approve or deny invoices that are submitted after analyzing the credit worthiness of the debtor. The construction company therefore has complete control over which invoices it would like to sell or be applied to the credit facility. Now with that being said, a factoring company will file a UCC lien on a company's accounts receivable in order to collect their advances should fraudulent activities occur against them. A bank does the same thing but will encumber all assets with a "blanket lien" to recover its loan should a default occur.

“Secondly, they may give you a pretty good advance rate and may even give you a decent short term rate (less than 15 days), but the rates jump significantly on day 16. No exceptions!" Everything is negotiated. If the negotiated rate changes on day 16, the construction company agreed to this in the contract negotiations. Additionally, there are options a construction company can exercise in the event an invoice is outstanding longer than anticipated. The construction company may replace the invoice with another one or return the advance with a pro rated fee. Most terms for a traditional bank line of credit are non-negotiable and not as flexible as a factoring or accounts receivable factoring agreement.

"Also, most construction factors (there are only 3 nationwide) contract that they can switch from non-paying customers to good paying customers so that they can protect their investment. What that means is that they will not absorb a bad debt, you will." Not much different from a bank line of credit. If the bank line of credit is used it must be repaid. No exceptions and the construction company absorbs the bad debt. However, most factors and the negotiated agreements inherently provide bad debt protection just because of the very nature of the transaction. A factoring company does not loan money and therefore, does not require repayment. A factoring company purchases the accounts receivable or in the case of an invoice factoring agreement, purchases the invoice. Therefore, should a debtor fail to pay the invoice due to bankruptcy, the factoring company has no recourse to get its money back from the construction company.

"Factoring can be a great bridge to get you over a hump, but don't rely on it for more than a few months. You see, companies who require factoring are in trouble. All factoring does is speed up your demise. I know this. Trust me." I totally disagree. Cash flow problems lead to the demise of a company, not factoring. There are viable and fiscally responsible factoring strategies that provide working capital, stability, and growth potential that many times a traditional bank line of credit cannot do. Most companies suffering from cash flow problems turn to bank lines of credit that further compound their cash flow problems with debt and/or repayment difficulties.

A good factoring or accounts receivable factoring agreement solves cash flow problems without adding debt to the balance sheet or incurring repayment terms. A factoring company is accomplishing the same thing most companies do on their own to speed up payments. That is, many companies already offer a discount for early payments on their invoices. The standard prompt payment discount is 2% in 10 days, net 30. This discount is tantamount to a factoring agreement. However, the prompt payment discount usually does not work because most companies "stretch" their accounts payable as long as they can because it is in their advantage to do so.

Furthermore, some large corporations take the generous discount, but still don't pay in 10 days. All a factoring agreement does is redirect that early payment discount to a third party and provides the immediate cash that the prompt payment discount failed to do. In many cases, a factoring company can provide the necessary rate and terms that mirror the standard prompt payment discount and provide the flexibility and the convenience that a bank line of credit can not do.



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