This term refers to getting a short-term loan based on the financial strength of your accounts receivable. This means that you sell the accounts receivable of your business to the factoring company at a discount in exchange for getting money now. Factoring is useful when you have to meet your business obligations, such as paying your bills, payroll, suppliers, and other business expenses while you wait for your customers’ payment for the products delivered or services supplied.
A factoring transaction would work as follows:
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The factoring company (factor) would look at your accounts receivable and take a percentage discount on the value of the receivables.
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The factoring company deposits a portion of the amount of the receivables (minus the percentage discount) to your company’s checking account and deposits a reserved balance on a restricted account. The factoring company holds the reserve on the restricted account in case your customer does not pay the invoice within 90 days; technically, it is your money.
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If your customer pays the invoice within 90 days, you get the money in the restricted account. If not, you have to pay the factoring company all the money disbursed to you plus the finance fees.
Factoring Types
There are several types of factoring loans. These include:
Recourse Factoring: If the factoring client’s customer does not pay the invoice, the factoring company has recourse to the client’s assets. The risk of non-payment falls on the client.
Non-Recourse Factoring: In this case, the factoring company takes the risk of non-payment.
Factoring Costs
A factoring company will charge a fee of 2 to 6% of the invoice amount. The rate might increase the longer the bill goes unpaid. For example, a factor could charge 3% if the invoice is paid in 30 days, 4% if it is paid in 60 days. In addition, you will pay a higher rate the lower the amount of the accounts receivable to be financed is. Other fees may apply such as upfront points, collateral-maintenance fees, and audit fees. Also, inquire what method the factoring company is using to calculate the fees. There are two methods, the prime plus method and the discount method. The discount method is favored by smaller factors because it results in higher fees.
Factoring Benefits
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A factor can lend you money based on your receivables even if your company does not have a long record of accomplishment. Some banks require a company to be in business at least two years before lending money to a prospective client. This is because they use your clients’ creditworthiness when buying your receivables.
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Factors tend to specialize in industries; it is a good idea to find a factor that is familiar with your business. They can help you not only with financing, but also with industry advice. They also run credit checks on your customers, making them an effective partner for growing your business.
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After factoring is approved, you will receive funds within 24 hours; this will help you plan your budget, negotiate better terms with your vendors (they will be paid faster), and set prices.
Factoring Drawbacks
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Some factors might require a long commitment period. For example, factors might ask you to commit to sell all your receivables to them for the next six months to a year. You might find this problematic if your cash-flow problems are temporary.
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If you are offered non-recourse factoring, the factoring company may attempt to collect on the invoice aggressively. This may affect your relationship with your customer.
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