What Is Factoring?
Factoring is a transaction in which a business sells its accounts receivable, or invoices, to a third party commercial financial company, also known as a “factor.” This is done so that the business can receive cash more quickly than it would by waiting 30 to 60 days for a customer payment. Factoring is sometimes called “accounts receivable financing.”
The terms and nature of factoring can differ among various industries and financial services providers. Most factoring companies will purchase your invoices and advance you money within 24 hours. The advance rate can range from 80% to as much as 95% depending on the industry, your customers’ credit histories and other criteria. The factor also provides you back-office support. Once it collects from your customers, the factor pays you the reserve balances of the invoices, minus a fee for assuming the collection risk. The benefit of factoring is that, instead of waiting one to two months for a customer payment, you now have that cash in hand to operate and grow your business.
Factoring is not a loan. No debt is assumed by factoring. The funds are unrestricted, providing a company more flexibility than with a traditional bank loan.
Factoring in Five Simple Steps
- You perform a service for your customer.
- You send your invoice to a factoring company.
- You receive a cash advance on your invoice from the factoring company.
- The factoring company collects full payment from your customer.
- The factoring company pays you the rest of your invoice amount, minus a fee.
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What are the Advantages of Factoring?
There are several reasons why factoring is a valuable financial tool for many businesses. The key benefit is that factoring provides a quick boost to your cash flow. Many factoring companies provide cash on your accounts receivable within 24 hours. This can solve short-term cash flow issues and help fuel the growth of your business. Factoring companies handle your customer collections, and may also evaluate your customers’ credit and payment histories.
Some other major benefits include:
- Factoring can be customized and managed so that it provides necessary capital when your company needs it.
- The financing does not show up on your balance sheet as debt.
- Factoring is based on the quality of your customers’ credit, not your own credit or business history.
- Factoring provides a line of credit based on sales, not your company’s net worth.
- Unlike a conventional loan, factoring has no limit to the amount of financing.
- Factoring aligns well with start-up businesses that need immediate cash flow.
Is Factoring Something New?
No, it actually goes back several 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.
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 and distribution, textiles, oil and gas, and staffing agencies. Companies use the cash generated from factoring to pay for inventory, buy new equipment, add employees, expand operations—basically any expenses related to their business. Factoring allows a company to make quicker decisions and expand at a faster pace.
The factoring process explained in five illustrated steps.
How Factoring Works
Here’s a fictional example to illustrate a common factoring situation:
ABC Transport is a trucking company that wants to double the size of its fleet over the next two years and serve more clients in the West. The company has just landed a new customer on the West Coast who needs freight shipped from Kansas City to Los Angeles. The customer will pay for the service within 30 days, but that won’t cover the immediate fuel, payroll and maintenance costs of running the route. The owners of ABC Transport have been in this situation before. They feel that the lack of available cash flow has prevented the company from taking on new business.
ABC Transport turns to a factoring company, selling the West Coast customer’s invoice in exchange for a 90 percent advance on the total amount within a day. The influx of cash replenishes the trucking company’s reserves, allowing it to run the Kansas City-Los Angeles route. Factoring also gives ABC Transport the flexibility to take on new customers as well.
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 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:
Some factors provide credit reports and other information on your existing and potential customers.
No credit services provided, which means you manage your own credit policy.
What is the Difference Between Recourse and Non-Recourse Factoring?
Recourse means the client ultimately takes the responsibility for the payment of the invoice.
Non-recourse factoring allows companies to sell their invoices to the factoring company, which assumes all of the credit risks for the collection of the invoice. Some factoring companies offer both recourse and non-recourse factoring.
What about Fees or Contract Terms?
Different factoring companies have different fee structures. Some only charge an overall factoring fee that is determined by monthly volume and the creditworthiness of your customers. Other factoring companies have additional fees that cover money transfers, shipping, collateral and other costs of doing business. Make sure the factoring company you work with is up-front and transparent about the fees it charges. Most factoring contracts also have an annual renewal term.
Is Credit Insurance Needed on Debtors?
Insurance is not typically necessary, but may be required in specific circumstances.