Opinion: Factoring: What You Don’t Know Can Hurt You

By Dudley Boyd

President

National Bankers Trust

This Opinion piece appears in the June 22 print edition of Transport Topics. Click here to subscribe today.

At one time or another, every business finds itself undercapitalized. Unfortunately, in these tough economic times, qualifying for a line of credit can be extremely difficult. As a result, increasing numbers of transportation companies are looking into factoring, with many of them taking the plunge and selling their accounts receivable to a factor.

Factoring is like getting payday loans, borrowing cash flow from tomorrow to pay bills today. But factoring does nothing to solve the bigger problem of being undercapitalized, which is the cause of poor cash flow. With these facts in mind, no business owner should consider factoring before doing some homework and answering three important questions:

• Is the business profitable, or is there a clear plan to become profitable?

• Can lower-cost financing be secured elsewhere?

• Is there a realistic plan to build capital and ultimately get out of factoring?

On the matter of profitability, businesses considering factoring must understand that no form of financing by itself can make a company profitable. Transportation operations must maximize profit by increasing revenue and cutting expenses — including owner compensation.

To be absolutely blunt, business owners who are unwilling or unable to make these difficult decisions may be better off closing their doors, preserving capital and offering the best chance to come back and fight another day.

Now consider the cost of factoring. This financing option can consume 30% to 50% of a carrier’s net income, so it is absolutely imperative to use lower-cost funds first. Consider selling property, equipment and other assets to raise cash, or borrowing money from friends and family. Furthermore, look for lines of credit available from specialty finance companies; they can be half the cost of factoring and just as easy to qualify.

After exhausting all lower-cost options and deciding to proceed with factoring — develop an exit strategy. The business must have a capital formation strategy that accrues and grows retained earnings, which becomes capital.

Saving every penny will help, but to accelerate the process, the business may want to work with a finance company that specializes in leveraging the time value of money and using the high yield proceeds to build capital. This approach can dramatically reduce the time to become properly capitalized, which is the only permanent cash-flow solution.

When companies turn to factoring, it is important to understand they are giving up control and ownership of their accounts receivable. This situation means the factor can do whatever it wants with “their” A/R, which can cause serious finan-cial and legal problems if a company ever decides to stop factoring or move to a company offering a better deal.

Some factors drag their feet when it’s time to release your accounts, which can leave you with zero cash flow for several days, so you must pay close attention to the termination provisions of your factoring agreement.

When you first make the factoring deal, the accompanying sales pitch may touch lightly on the issue of minimum volumes, intimating that it is just to establish a credit limit. As time goes by, you and the factor may seem to have forgotten the topic — until it’s time to end the relationship, and then suddenly those minimum-volume fees kick in.

Let’s say a carrier processes $100,000 worth of invoices a month with a factor. Then the economy takes a nose dive, and volume drops to $60,000 a month. The factor will keep track of the fees the firm “lost” because of that $40,000-a-month shortfall. Time passes, and eventually the carrier decides to stop factoring or move to a better deal. That’s when the minimum volume provision suddenly become an issue. If the trucking company wants out, freedom may cost tens of thousands of dollars.

This issue is a good reason why business owners need an experienced business lawyer to explain their rights and obligations and in particular to understand the cost of terminating the factoring agreement.

Factoring companies also may require 12-, 24-, or 36-month agreements, implying this contract is required to get the lowest rate or for the factor to recover setup costs. Don’t believe it.

Refuse to sign any agreement that doesn’t allow termination at any time. This provision will ensure that you receive the highest level of service. Like most things in life, everything is negotiable. Be informed, shop around and be prepared to walk away if you want to get the very best deal.

To find the best deal, do a life cycle cost analysis: Just like buying a truck, the focus should be on the cost of ownership over its life. For example, when considering factoring rates, be sure to include fees, interest, overnight delivery costs, bank wire costs and all other costs associated with doing business with the factor over the term of the relationship — 48 months, 60 months, etc. And remember those three questions before deciding whether or not to give factoring a try.

National Bankers Trust, Memphis, Tenn., provides financial services to the transportation industry, including proprietary lines of credit.