Factoring is a financial agreement and a kind of debtor finance where a business (including a small business) sells its invoices (i.e., accounts receivable) to another party (known as the factor) at a diminished rate or discount. This is done with receivable assets in order to meet the immediate and present cash needs of a business. Factoring is also known as accounts receivable financing. It is not the same as factoring invoices, which is a type of borrowing that uses accounts receivable assets for collateral of the loan.
How does it work?
If your small business is experiencing a large amount of slow-paying customers causing a cash-flow squeeze, it’s possible to sell your accounts receivable or invoices to a specialized factoring company. The factoring company advances the greater part of the invoice amount – typically between 70% to 90% – after it checks out how credit-worthy the billed customers are. Once the bill has been paid, the factoring company forwards the balance, less a factoring (or transaction) fee.
Many companies like factoring because they’re able to get their money quickly instead of having to wait the normal 30-60 days for payment. Once a business sends invoices to the factoring firm, it can have money in its pocket within 24-48 hours. Factoring is sometimes used by companies to get their business off the ground. A factoring company examines the financial solvency of a business’s clients, instead of a bank’s focus on the credit-worthiness of a business when deciding whether or not to approve a loan.
Is factoring expensive?
The short answer is yes. A factoring company can charge several more percentage points than a traditional lender. It is becoming increasingly more popular and currently accounts receivable financing amounts to billions of dollars a year, and is widely used. Some businesses use factoring as either a stop-gap measure or to be able to meet their cash-flow needs. Other companies prefer to do their factoring with banks, which usually means more paperwork, or with outside investors who might want a piece of your business.
Factoring isn’t the best choice for businesses that send out small denomination invoices in the thousands because the factor might charge service fees for reviewing or assessing each invoice for risk factors involved. However, a factor customer won’t need to worry about either credit checking or billing (or about staffing requirements for those functions) since all collection handling is covered by the factoring firm.
How can factoring help small business owners?
There are many benefits of factoring accounts receivable for small businesses. First, it eliminates bad debt. The factor will take on the possibility of bad debt, and this item can then be eliminated from your business’s income statement. Second, your professional collections will be done by a good factor, which will both collect receivables in a skillful manner, and will also eliminate any overhead that’s associated with the whole collection process.
Third, your small business will have unlimited capital. Factoring is a unique financing source that grows along with your sales. When your sales increase, there will be more cash available for your use, allowing your business to always be able to meet demand.
Fourth, your small business will be able to take advantage of early payment and volume discounts. An increased cash flow will allow your business to be able to benefit from discounts that can immediately affect your bottom line.
Fifth, no debt will be incurred. Factoring isn’t a loan, so your small business isn’t incurring any debt. Your balance sheet will look better, and that, in turn, will allow you to either sell your company or obtain alternate types of financing. Sixth, the principals in the company don’t have to guarantee funding repayment (they will have to guarantee against disputes or fraud, but they won’t have to guarantee against a customer’s inability to pay). Finally, factoring is simple and it’s quick. The application process required for establishing a factoring relationship is a great deal easier than other forms of financing. In addition, you won’t need any business plans, projections, financial statements, or tax returns.