Factoring is an alternative source of financing that involves selling your outstanding accounts receivables at a discount to a factoring company. One of the advantages is that you can get cash almost immediately, so this may be a good source of short-term financing when you need funds for growth or you are unable to obtain bank loans. But factoring is generally more expensive than other forms of financing.
How Factoring Works
Factoring is not the same as other forms of accounts receivable financing, such as taking out a loan or obtaining a revolving line of credit with a bank, with your accounts receivable pledged as security. And factoring is not the same as turning accounts over to a collection agency.
Selling Your Receivables
In a factoring transaction, your business basically sells its receivables to the factoring company at a discount. Once you factor an invoice that you have issued to a customer, you transfer your rights to collect that amount. The factoring company acts as the principal, and not as your agent. Customers are notified that their invoices have been factored, and they make their payment directly to the factoring company. You have basically transferred your right to the amount invoiced, and your responsibility for collection, to the factoring company in return for a discounted amount of immediate cash and the balance of payment, less the factoring company’s fee, once the customer pays.
Advance and Reserve Factoring
For example, in the advance and reserve type of factoring, which is the most common for small businesses, you sell your receivables to the factoring company at approximately 60 to 80% of their face value, and you receive that amount in cash up front, with the balance remaining as a reserve. The factoring company then takes over responsibility for collection. When the customers pay the invoices, the reserve is released and the factoring company deducts its fee, which can be from around 1% to over 5%, called the discount rate, and pays you the balance.
How the Discount Is Determined
The factoring company is more concerned with your customers’ ability to pay than with your own business’s credit rating. In this sense, the quality of your receivables is what counts for a factoring company, and will probably influence the amount of the discount. This discount varies considerably, and will depend on the factoring company, and probably particularly on the age of the receivables. Current invoices will yield a lower discount than older receivables, and delinquent accounts that are over 90 days past due will probably be difficult to factor.