Companies have several alternatives when seeking financing and factoring can be a valuable alternative. Factoring is when a business sells its accounts receivable (invoices) at a discount to a third party called a factor. The main purpose is to facilitate immediate payment of the invoice, allowing a business to accelerate its cash flow and enhance growth.
A factor provides funds to the invoice seller in the form of a cash advance between 70-90 percent of the invoice face value. The balance of the invoice, referred to as the reserve, is paid to the seller, less the factor’s fee (commission) and other charges, upon collection of the invoice.
Let’s be very clear here: Factoring is not a loan. It is the purchase of a financial asset by the factor from the seller. Where a bank focuses on the creditworthiness of the business seeking a loan, a factor is more concerned with the creditworthiness of the invoice seller’s client, the “debtor.” When the seller sells one or more of its invoices/receivables, the factor obtains all of the rights associated with the receivable, and the account debtor is notified of the sale and pays the factor directly for the invoice.
Factoring offers a number of benefits. First, because a factor makes its credit decisions primarily on the strength of the seller’s customer rather than the seller’s financial strength, factoring can be a less costly option than traditional banking. As a financial tool, factoring can increase the velocity of cash flow, effectively increase working capital, and help to avoid problems that slow-paying customers can create. Factoring can also allow a company to take advantage of profitable opportunities requiring additional cash—it can turn your unpaid invoices into immediate cash instead of having to wait 30 to 60 days or more.
Companies that provide “business to business” goods or services and offer terms can benefit the most from factoring. This includes a variety of industries such as transportation and logistics, manufacturing, distribution wholesalers, communications, janitorial services, food suppliers, and staffing agencies.
Businesses that cannot utilize or benefit from factoring are companies that provide services to the public and receive immediate payment by means of cash or credit card. Typically this would
include retail establishments such as restaurants, stores, and gas stations. The marketplace has other alternatives for establishments like this to enhance their working capital models.
Factoring costs to the seller are generally a percentage of the gross amount of the invoice calculated on a monthly basis of between 1.5 and 3 percent, depending on the creditworthiness of the debtor and the amount of the invoice.
Factoring has become an accepted means of financing. Many large commercial buyers encourage sellers to find a factor to support their business growth. Many large firms (debtors) have also developed departments that specialize in facilitating the process of dealing with transactions with factors. Factoring can be a very effective alternative for solving a number of challenges. Businesses must consult with their financial team and a knowledgeable CPA to see if factoring is the right answer for them.
This article was originally published by “Your Business” on February 28, 2014 . Click here to view original article.