Factoring is a form of asset-based finance that can be utilized by small and medium-sized enterprises (SMEs) to support cash flow by generating funds against unpaid invoices. It is a financing option available to businesses that offer products or services on credit to other businesses. In factoring, a debt factoring provider, known as a ‘factor’, purchases accounts receivable or unpaid customer invoices from a business. The factor then owns the debt and chases payment from the customer.
Factoring is a cash flow solution designed to improve cash flow by ensuring invoice payment is received much sooner. Since customer credit is based on net-30, net-60, or net-90-day terms, it can take one, two, or three months before a business is paid for its work. Therefore, it is factoring works by advancing the majority of the value of customer invoices (usually 80-90%), with the balance made available once the invoices are paid, with fewer charges.
Factoring fees are a discount rate, typically between 0.5% and 5% of the monthly invoice value. The discount rate is charged weekly or monthly, so the longer the customer pays, the higher the total factoring cost. While the cost of factoring may be more than a conventional loan when the annual percentage rate (APR) is calculated, there is a difference in the total cost because, in factoring, the cash is borrowed for a short period.
Factoring provides more than just financing. It combines the provision of finance with a service element, helping the business with credit control, which can be particularly valuable for smaller businesses. The factor works on behalf of the business, managing the sales ledger and collecting money customers owe. This relationship is transparent, and customers of the business will be aware that a factor is involved.
There are two types of factoring: recourse factoring and non-recourse factoring. In recourse factoring, the liability for invoice payment remains with the business, which has sold its invoices to the factor. The advance and the factoring company’s fee must be repaid if the customer does not pay after a specified period. In non-recourse factoring, the risk of non-payment passes to the factor and is typically more expensive. If the customer does not pay, the cash advance is retained by the business that sold its invoices, and the factor takes the loss. A non-recourse factor will be far more interested in a customer’s creditworthiness.
Export factoring is also available to support businesses selling internationally. Credit control, managing, and chasing up invoices can be expensive for a small growing business. Debt factoring can free up constrained resources for use elsewhere in the business. Where sales are regular, factoring provides a smooth availability of cash flow to fund operations and potential investment in plant and equipment. However, some small businesses can become reliant on debt factoring to finance working capital long-term, and it is a more expensive way of borrowing.
Risk also involves handing over customer interaction to a third-party focused only on collecting cash. If this is an option, it may make sense to use factoring for some customers and not others. Overall, factoring is an effective way for businesses to obtain finance, manage cash flow, and improve their credit control.