Following on from my post on working capital, I want to make a quick mention of the financing (and factoring) available to businesses to solve working capital issues. With this type of financing, a company invoices a customer, sends a copy of the invoice to the finance company, and the finance company extends a loan, which uses the invoice as security. When the customer pays the invoice, it pays the finance company to settle the short-term loan against the invoice. The terms of the financing determine whether the customer pays the financier directly or indirectly and how much of the invoice will be lent (usually up to 80%).
This type of financing (called trade, debtor or receivable financing) is most suited to B2B or to B2C in which invoices are used. And, the distinction between debtor financing and debtor factoring is that the former involves lending against the debtors, whereas factoring involves the purchase of debtors at a discount. The discount in factoring represents a financing cost in the same way an interest charge on debtor financing represents a cost.
In some cases, debtor financing or factoring competes against private equity. The process of securing financing or factoring is much quicker and less involved than securing private equity. Both are arguably more expensive than other forms of capital, but of course, a private equity investment is more than just short-term funding. So, the decision between the two depends on the objectives of the business. And, there’s no reason you can’t have both, which is really the best of both worlds for most businesses.
An important side note is that debtor financing and factoring is a common source of business fraud. As you can imagine, it’s quite easy to manufacture fake invoices to have additional funding advanced. These fake invoices are fresh air invoices and the underlying fraud is fresh air fraud. The other important note is that the focus is on the creditworthiness of debtors rather than the business itself… for obvious reasons. So, it can be much easier to secure if you have solid customers, even if you are having performance issues.