Factoring acts as an instrument to obtain quick access to short-term financing and reduce risks related to payment delays and defaults by buyers. Here the seller sells its receivables to a ‘Factor’ (financial institution) at a discounted rate. Once the sale is done, the ownership of the receivables is immediately transferred to the factor. After a certain time, the factor or the company collects payments from the debtors. Factoring thus plays as the helping hand for the company to improve its cash flows and cover its credit risk.
A factor is a third party that purchases part or all of a company’s accounts receivables in exchange for a percentage of the invoice. The “factor” then owns the outstanding invoices and collects from the customers. In this process, it earns a profit from the difference between the discounted rate for buying the account receivables, and the full invoice amount collected from the customer.
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How Factoring Works
- The concerned business owners can contact a factor, there are several independent factoring companies and banks offering the service. You can research and choose the one that is the most benefitting for your situation.
- The factors usually target’s specific businesses based on their annual revenues and volume of invoices produced each year. There are also factors who specialize only in particular industries.
- Fees usually range between 2% – 4.5% of the total invoice amount for every 30 days. Once the invoice is paid, the factor will pay the balance of the invoice minus the agreed-upon fees to the business. The fees are based on variables such as the credit quality of the client base and the size of the invoices.
The Two Types of Factoring
The two main kinds of factoring agreements are –
- Recourse factoring: A company sells its accounts receivables to a factor with the belief that they will pay the factor for any invoices the factor is unable to collect. This is the more prevalent form of factoring in the United States.
- Non-recourse factoring: The factor takes in all the risk for uncollected invoices and the business is not liable. As this agreement carries a higher risk for the factor, the transaction fee is almost one percent higher than a recourse factoring agreement.
Is Factoring Right for My Business?
Factoring is a valid option for many businesses. It is more prevalent in the manufacturing sector as they have a longer cycle for producing consumer goods which are distributed through multiple channels before ultimately reaching consumers.
Pros of Factoring
- Factoring is a good option for small businesses looking for quick access to capital without debts, loss of equity, or encumbering capital assets.
- Factors provide immediate working capital so the company can continue to produce and distribute without interruption, along with giving clients acceptable terms to pay.
Cons of Factoring
- Factoring is comparatively more expensive than the cost of traditional lines of credit—though it is less costly than missing sales or letting growth overwhelm the business.
- The business owner has to allow the factor to collect the invoice directly from the customer.
With Factoring like for any other financing option, it’s important to do your research and make sure that it is a good option for you and your business. Try and completely understand the terms of any factoring agreement before you sign on the agreement.