When it comes to new products and services, German small and medium-sized enterprises are considered particularly innovative. In the area of financing, however, many companies have been reluctant in the past to venture beyond familiar territory and have stuck with traditional forms such as bank loans.
However, given the stricter guidelines that banks must follow when granting loans—for example, since the Basel III regulations took effect last year—this can have negative consequences. Companies whose equity ratio is too low may be offered unfavorable loan terms or receive smaller loan amounts. For this reason, more and more SMEs are rethinking their approach and turning to alternative forms of financing, such as factoring.
In this process, a company sells its receivables to a financial services provider, known as a factor. The factor permanently assumes ownership of the outstanding receivables and, in return, pays the seller 80 to 90 percent of the invoice amounts, minus the agreed-upon factoring fee. The seller receives the remaining portion—known as the security retention—once their customers have paid their invoices in full. If the customers fail to pay, the security retention is still credited to the seller’s account no later than 150 days after the invoices’ due dates. Factoring is therefore a purchase transaction and not, as is often assumed, a credit transaction.
According to the Federal Association of Factoring for Small and Medium-Sized Enterprises (BFM), the number of small and medium-sized enterprises using factoring rose by 7.7 percent in 2014. The purchase volume grew by just under four percent, as revealed by an internal survey conducted by the association. “In a representative study by the BFM, which surveyed more than 1,500 German companies with revenue of up to 50 million euros, nearly half of small and medium-sized enterprises consider factoring to be an attractive financing option,” said Volker Ernst, the association’s CEO.
Quick Access to Cash, High Security
The use of factoring offers companies several advantages. First and foremost is the protection against bad debt provided by the factoring firm. Since the client quickly receives the value of the receivables portfolio, payment defaults and the associated liquidity bottlenecks are a thing of the past for them. In times when companies are waiting longer and longer—and often in vain—for their customers to settle outstanding invoices, this is a crucial factor: On average, it takes 46 days in Germany for the money to reach the supplier’s account. Factoring therefore represents a sensible alternative to trade credit insurance, which pays out much later.
Thanks to the rapid inflow of cash, factoring clients can, in turn, reduce their liabilities—which in turn shortens the balance sheet and increases the equity ratio. The equity ratio, in turn, is an important criterion for banks and savings banks when granting loans. The higher it is, the better the terms. Thus, factoring has a positive effect on companies’ credit ratings and loan terms.
Another advantage: it creates greater financial flexibility. The freed-up funds offer opportunities for business growth, for example by being invested in research and development. Furthermore, factoring clients can use these liquid funds to pay their own suppliers’ invoices early, thereby taking advantage of discounts offered and saving money on purchases of goods.
Reliable Financial Planning
If the factoring firm also handles accounts receivable management, costs can be reduced and resources can be allocated elsewhere. Since the factor assesses the creditworthiness of the debtors, the company also gains a clear overview of its customers’ creditworthiness. If, for example, one of them receives a poor rating, the company can adjust payment terms accordingly in advance or even decide not to do business with that customer at all. This risk assessment is particularly valuable for international transactions where the company lacks long-term experience. Outsourcing the credit assessment also ensures continuous monitoring of accounts receivable—a task that smaller companies, in particular, often neglect.
Despite the numerous positive effects, there are still reservations about factoring. A common concern is that business partners might view the use of factoring negatively. Ernst comments: “Times are changing: Today, factoring is even seen by many companies and banks as a mark of quality for good corporate management. In any case, this type of financing is a testament to creditworthiness, as the factor only enters into contracts after a thorough review.” Factoring thus stands for reliable and secure financial planning—a financing option that grows along with the company’s revenue.
