Factoring

Factoring is often used synonymously with accounts receivable financing. Factoring is a form of commercial finance whereby a business sells its accounts receivable (in the form of invoices) at a discount. Effectively, the business is no longer dependent on the conversion of accounts receivable to cash from the actual payment from their customers, which takes place on typical 30 to 90 day terms. Businesses benefit from the acceleration of cash flow.

Factoring is considered off balance sheet financing in that it is not a form of debt or a form of equity. This fact makes factoring more attainable than traditional bank and equity financing.

There are usually three parties involved when an invoice is factored:

Types of factoring

Notified, or full service factoring

With notified factoring, the debtors are aware of the finance facility as the factoring company normally does the credit control, that is, collects the outstanding debts.

Confidential, or invoice finance

With invoice finance, the facility is confidential, with the seller retaining the credit control function.

Recourse factoring

Recourse factoring is now the most common type of factoring transaction. This factoring transaction allows the factor to go back to the seller if payment is not received (normally after a 90 day period). The credit risk does not transfer to the factor during the recourse factoring process.

Normally, in the event of non-payment by the customer, the seller must buy back the invoice with another invoice (credit worthy). Recourse factoring is typically the lowest cost for the seller because the risk for the factor on the funding transaction is lower.

Non recourse factoring

Non recourse factoring puts the risk of non-payment, in the event the debtor becomes insolvent, fully on the factor. If the debtor can not pay the invoice due to insolvency, it’s the factor's problem to deal with and they cannot seek payment from the seller. The factor will only purchase solid credit worthy invoices and often turns away average credit quality customers. The cost is typically higher with this factoring process as the factor assumes greater risk.

New Company Factoring

Sometimes, because the seller is a new company, it may find it difficult to secure traditional bank financing. An alternative source of financing that is becoming more popular for small or new companies is called factoring. Factoring is the sale of accounts to a finance company (the factor) in order to gain immediate access to the cash owed to it by its customers. Instead of sending bills directly to the customer, the company sends its invoices to the factor, who immediately pays the company–thereby eliminating the 30, 60, or even 90 days of waiting that normally follows a billing cycle.

For example, suppose a manufacturing company secures a contract to sell its widgets to a large retailer. Upon delivery of the merchandise to the retailer, it sends the bill through the factoring company for payment. The factor pays the manufacturer the face value of the invoice less a discount fee (2–10%) depending on the nature of the contract and the creditworthiness of the retailer. This immediate access to the cash flow allows the manufacturer to meet its commitments and pay its bills in a timely manner. The retailer pays the factor when the bill comes due for the widgets it purchased from the manufacturer.

Factoring can be a very expensive source of financing and is only recommended to companies that are growing faster than their current financing permits. Because factoring can be expensive, many companies use it only as a financing means of last resort. Factoring allows a company in financial difficulty to focus attention on the operations of its business as opposed to spending time and resources focused on how it will make payroll, for example. Depending on the state of the firm, factoring can be a useful financial tool; one that business owners should explore.

Factoring has been available to a variety of companies for many years. Some factors specialize only in retail financing, others specialize in freight-bill factoring for trucking companies, and others only factor invoices for manufacturing companies. Factoring may be more expensive than traditional bank financing but often it is the only source of financing that some new or under-capitalized companies can find.

Smart Factoring Strategies

With more flexible terms factoring begins, the client can increase prices 1% to 5% to help cover the factoring cost.

In many industries customers expect to pay a few percentage points higher to get flexible sales terms.

The client can avail cash discount from the suppliers for prompt payment from 2% up to 10% (depending on the industry standard). When the client make cash payment on the day of purchase from suppliers he could avail large cash discount.

With benefits coming from both the supplier and the customer. Thus the factoring cost can be covered by using smart factoring strategies.

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