Accounts Receivable Factoring (FACTORING)
What is Factoring?
Factoring is commonly referred to as accounts receivable factoring, invoice factoring, and sometimes accounts receivable financing. Factoring is a financial transaction and a type of debtor finance in which a business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount.
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- You perform a service for your customer.
- You send your invoice to a factoring company.
- You receive a cash advance on your invoice from the factoring company.
- The factoring company collects full payment from your customer.
- The factoring company pays you the rest of your invoice amount, minus a fee.
Advantages of Factoring
- LARGER AMOUNTS: Because accounts receivable factoring is based primarily upon accounts receivable, small businesses with large amounts of accounts receivable for goods or services sold to financially strong customers can often obtain a bigger line than they would qualify for with conventional bank lenders. This is because factoring is based on the credit strength of your customers. Banks look more at your business's credit strength to support their loans. Consequently, often factoring companies can provide more financing more quickly than banks.
- QUICKER SET-UP AND FUNDING: Most accounts receivable factoring lines can be approved, set up, and funded in just a few weeks. Banks typically require more time to perform their credit review of your company… perhaps even waiting for the upcoming fiscal period closes or audit results. The faster setup of accounts receivable factoring lines is because factoring companies have simpler more streamlined underwriting requirements. Again, they are able to do this because they are relying significantly on the credit strength of your customers.
- EXPANDS QUICKLY WITH GROWTH: Most factoring companies can expand their financing for you as fast as your business grows, even if your company has little track record performing that much business. Factoring companies have no bureaucracy hindering the increase of line size. So you are not likely to “outgrow your line” as easily. Just be sure you have a factoring company big enough to accommodate your growth ambitions.
- NOT A LOAN: A factoring company is not making loans. They are purchasing the accounts receivable with cash. This has the same result of increasing working capital but many accountants would not show this as a liability on the balance sheet the way a bank loan would appear. So factoring, instead of borrowing, reduces balance sheet debt resulting in a lower debt-to-equity ratio.
- LESS COSTLY THAN EQUITY: In need of financing many businesses turn to equity investors. For some business investment and expansion purposes, there is no substitute for equity capital. However, most equity investors expect higher returns than the costs of accounts receivable factoring, and new equity contributions dilute the ownership stake of existing owners often even shifting control. Most factoring arrangements have no dilutive effect on shareholders.
- IMPROVES YOUR TURN: Many factoring companies verify invoices with your customers and follow up promptly if your invoices are not paid on time. These gentle reminders to your customers usually result in more timely payments and it frees you and your staff up from having to perform these administrative tasks to focus on your product or service delivery.
== Disadvantages of Factoring
- MORE EXPENSIVE THAN A BANK LOAN: Accounts receivable factoring is more expensive than bank financing because of the transactional work with the invoices the factoring company does to advance more money more quickly. Costs vary significantly between factors and comparing rates and fees can be challenging. Consequently, invoice factoring cost drivers need to be carefully understood.
- SHRINKS AS BUSINESS CONTRACTS: Factoring can grow rapidly with you but also contracts as quickly if your business is contracting. So factoring may not be a good solution for businesses with great seasonality or other significant downward fluctuations in revenue.
- NOTIFICATION: Factoring companies typically require that you assign the accounts receivable to them. This means that your customers’ accounts payable departments will be notified to send payments to the factoring company’s lockbox. Some businesses are concerned this will affect their customer relationships but factoring is such a commonly used form of financing that a professionally delivered factoring service rarely draws much notice from customers. Typically, the process is routinely handled in the Accounts Payable department. However, it is important to thoroughly understand the terms of a factoring agreement to know if costs or delays in payment may result from the notification process.