How Does Factoring Work?
Factoring is a transaction in which a business sells its invoices, or receivables, to a third-party financial company known as a “factor.” The factor then collects payment on those invoices from the business’s customers. Factoring is known in some industries as “accounts receivable financing.”
The main reason that companies choose to factor is that they want to receive cash quickly on their receivables, rather than waiting the 30 to 60 days it often takes a customer to pay. Factoring allows companies to quickly build up their cash flow, which makes it easier for them to pay employees, handle customer orders and add more business.
What is a Cash Advance?
When you factor an invoice, the factoring provider advances to you a percentage of that invoice value, usually within 24 hours. The factor will then pay you the balance of the invoice, minus fees, after it collects payment from your customer. The cash advance rate can vary depending on what industry your company is in and whom you choose as a factor. The advance rate can range from 80% of an invoice value to as much as 95%. Your industry, your customers’ credit histories and other criteria help determine the advance rate you receive.
Why Not Just Wait for My Customers to Pay?
The long wait on customer payments can limit the amount of cash your company has on hand to meet expenses and achieve financial goals. While there are many advantages to factoring, the main benefit is quick payment on your invoices. Let’s say, for example, that your company averages $100,000 in receivables each month. However, you have nothing to show for it at month’s end because your customers wait longer than 30 days to pay. Factoring ensures that you receive cash on those invoices immediately. Even at an 80% advance rate, your business can count on having $80,000 in the bank at month’s end, instead of zero.
Factoring in Five Simple Steps
This simple graphic illustrates how a factoring transaction typically works.
What Are Some Other Benefits of Factoring?
Boosting cash flow is the main reason most companies factor. However, factoring provides many other advantages as well. Here are a few of them:
- Factors provide free back-office support, including managing collections from your customers. This gives you more time and resources to focus on growing your company.
- Factoring is based on the quality of your customers’ credit, not your own credit or business history.
- Factoring can be customized and managed so that it provides necessary capital when your company needs it.
- Factoring is not a loan, so you do not incur debt when you factor.
- Factoring is scalable, meaning the amount of funding can grow as your receivables grow.
What Kinds of Companies Factor?
Companies of all sizes, from one-person businesses, to Fortune 500 corporations, use factoring as a way to increase their cash flow. Factoring spans all industries, including trucking, transportation, manufacturing, government contracting, textiles, oilfield services, health care and staffing agencies. Companies use the cash generated from factoring to pay for inventory, buy new equipment, add employees and expand operations—basically any expenses related to their business. Factoring allows a company to make quicker decisions and expand at a faster pace.
How Long Has Factoring Been Around?
Factoring actually goes back many centuries. The origin of factoring lies in overseas trade among nations. It became a part of doing business in England as early as the 1400s, and came to America with the Pilgrims in 1620. Like all financial tools, factoring has evolved over the years. It grew in the United States as an effective way for companies to build more cash flow, due to limitations companies faced securing loans in the nation’s fragmented banking system.
How Much Do I Need to Factor?
It depends on your company’s unique business needs. Some companies factor all of their invoices, while others factor only invoices for customers that take a longer time to pay. The volume of receivables that a company may choose to factor can range from a few thousand dollars to millions of dollars a month.
Factoring versus a Traditional Bank Loan
Factoring, or “accounts receivable financing,” is a quick, flexible way for businesses to build up their cash flow. Here is how factoring differs from a bank business loan or line of credit:
What is the Difference Between Recourse and Non-Recourse Factoring?
Recourse factoring means that the factoring client ultimately takes responsibility for payment of an invoice if the factor cannot collect payment from the customer, or debtor.
Non-recourse factoring allows companies to sell their invoices to the factoring company, which assumes all of the credit risks for collecting on the invoices. Some factoring providers offer both recourse and non-recourse factoring to their clients.
What about Fees or Contract Terms?
Different factors have different fee structures. Some only charge an overall factoring fee that is determined by the monthly volume of receivables and the creditworthiness of a client’s customers. Other factoring providers have additional fees that cover money transfers, shipping, collateral and other costs of doing business.
When selecting a factor, pay close attention to the fee structure. Make sure the factor you work with is up-front with you about its fees as well as the term of the factoring contract. Most factoring contracts are 12 months with annual renewals.
Is Credit Insurance Needed on Debtors?
Insurance is not typically necessary, but may be required in specific circumstances.
For much more information about factoring, please read the other articles in The Complete Guide to Factoring.