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.

Recourse or Non-Recourse

Factoring transactions can be either recourse or non-recourse. In a recourse transaction the company selling its receivables must repay the advance and the factor’s fees if the customer does not pay the invoice by the recourse date, which is usually 90 days after the invoice date. In a non-recourse transaction the factor assumes the risk of non-payment. Recourse and non-recourse terms refer to the risk of bankruptcy or insolvency of the customer, and do not refer to trade disputes or returned merchandise. It should also be kept in mind that in a non-recourse transaction, the credit-worthiness of the customer may be scrutinized more closely before the factor agrees to buy the receivable.

Advantages of Factoring

Factoring accounts receivable can be beneficial in various different business situations. The following are some of its comparative advantages:

• By factoring your accounts receivable you can have almost immediate access to cash.
• Factoring can improve your cash flow by providing an ongoing source of cash. If you continue factoring, new invoices will replace those that are paid. As long as your business generates sales and accounts receivable, you can factor them and receive cash.
• Factoring is a form of financing that does not necessarily depend on your business’s credit rating, since the factoring company is interested in the quality of your customer accounts. This can be particularly attractive to a new start-up business that cannot get traditional financing in the form of bank loans.
• Only your receivables are used as collateral (if the receivables are factored under recourse terms; under nonrecourse terms there is basically no collateral), so you can use other assets, such as property and equipment as collateral for borrowing.
• The relationship with the factoring company is not debtor and creditor, and there are generally no long term contracts involved, so factoring can be a flexible source of financing. But the opportunity is still there to establish a lasting relationship with the factoring company.
• Factoring eliminates the need to spend time and effort in collection activities, since the factoring company takes over these responsibilities. By effectively outsourcing these functions, your business may be able to save on overhead administrative expenses.
• With the cash you free up from receivables that may be 30, 60, or 90 days outstanding, you can take advantage of supplier discounts, or you can purchase the materials you need for a big job that may be awarded to you. If you had to wait for your customers to pay before you could purchase the materials you need, you may miss out on opportunities to expand your sales. Factoring can provide the cash needed by companies that are in periods of rapid growth.
• By factoring your receivables and showing a stronger cash position on your balance sheet, you may find it easier to obtain traditional bank financing.
• By using your own resources (your receivables) to finance your operations, you may be able to avoid taking on more debt or having to raise more equity, possibly giving up part of the ownership of your business.
• Factoring can help protect your company’s credit rating by providing cash to meet payment due dates.

Disadvantages of Factoring

Factoring has a couple important drawbacks that must be taken into consideration:

• Cost is probably the biggest disadvantage. Factoring can be an expensive form of financing. A discount rate of 1% to 5% on invoices with terms of 30 to 60 days results in a much higher annual rate than other traditional forms of financing.
• You lose control over the collections process. This may have an effect on your relationships with your customers, depending on how the factoring company handles collections.

Is Factoring Right For My Business?

There are several variables that should be weighed in your decision about whether to factor your accounts receivable.

Aspects to Consider

Your cash flow will be a primary consideration, as will the availability of other forms of financing, such as bank loans. The amount of working capital you have tied up in accounts receivable with payment terms of 30, 60 or 90 days, will influence your decision. The credit-worthiness of your customers will affect the advance rate and the discount rate that factors are willing to offer.

Your line of business will be an important consideration. Businesses that have a significant time lag between the purchase of materials and final collection from the customer may be good candidates for factoring.

The stage of development of your business will also be important. Start-up businesses that cannot obtain bank loans or other sources of financing can benefit from factoring. During periods of rapid growth, factoring may provide a needed injection of cash to generate more revenue by purchasing raw materials and supplies at a discount. It may also be advantageous when your business has been awarded a large job that will require immediate cash outlays for materials and other costs, but that will generate more income.

What Types of Businesses Can Benefit from Factoring

Factoring can be a good option for a small business that is experiencing difficulties with liquidity and needs cash to meet its obligations. In this case, factoring can help you get through these periods without incurring additional debt and without negatively impacting your credit rating. You will be using your own assets – your receivables – to finance your operation. In a highly leveraged business that already has a significant debt load, factoring may be a way of improving cash flow without incurring additional debt. In a business that has tax liens or other credit problems, factoring is an option that is not adversely affected by your credit record, since the factor is more concerned with the customer.

How To Proceed

Once you decide to factor your accounts receivable, do some research first, to find the right factoring company for you. After that comes the application process and presenting the documentation the factoring company needs.

Doing Your Homework

As in any business transaction, you should deal with a reputable company, preferably recommended by a professional advisor or business associate. Do some research on the factoring companies you are considering and compare their quoted discount rates. You should be clear about the terms and conditions of the factoring arrangement beforehand. Ask any questions you may have before signing the agreement. You may want to consider using an experienced broker, that can find the best factoring company for your business.

The Application Process and the Documentation You Will Need

The application for getting started with a factoring company is normally a relatively short process that could take just a few working days. Your receivables should be properly documented, supported by the invoices to be factored, and your product must have been delivered and accepted by the customer, or your service completed, before the factoring company will purchase the receivables.

You will need your most current accounts receivable aging report, a sample invoice, and in some cases, your most recent financial statements. The factoring company may charge you a one-time fee, once you agree to their proposal, to cover administrative costs, filing fees, and other expenses.