After a seller makes a sale and issues an invoice to their customer, they often have to wait for a period between 30 to 90 days and in some cases even upto 180 days for the customer to pay the invoice amount.
This is a challenging situation for them as they may have ongoing expenses which require immediate cash, and waiting for the invoice maturity period to end before receiving its payment may disrupt operations due to a cash crunch. To avoid such situations, businesses turn to factoring companies.
What is a Factoring Company?
A factoring company is an organisation that purchases a company’s unpaid invoice at a discount. This is callen an invoice factoring program.
It serves businesses that require a boost in their cash flow but have to wait for long time periods to receive invoice payments.
A factoring company provides such businesses quick access to cash in exchange for these invoices.
Instead of waiting for the completion of the maturity period, the business gets immediate access to cash equivalent to upto 80% of its invoice value in a matter of a couple of days.
This transaction leads to the transfer of ownership of the invoice and the payment process from the business to the factoring company, also referred to as the factor. Once the customer settles the payment with the factor, the factor pays the rest of the amount owed to the business after deducting a factoring fee.
// Also Read : What is Small Invoice Factoring, and How Does it work?
Industries that use Factoring Solutions
The need for factoring services arises when companies need to sustain their daily operations, pay their employees, purchase inventory, minimise administrative expenses, reinvest in other assets, handle fluctuations in sales because of seasonal variations, slow-paying clients, and gain further access to capital.
There are several industries that benefit from factoring solutions as a way to arrange for an influx of cash flow for reasons, such as:
- Staffing
- Logistics and Transportation
- Manufacturing
- Professional Services
- Textile and Apparel
- Distribution
- Facility Services
- Oil and Gas
- Janitorial Services
- Consulting
- Food and Beverage
- Wholesale
- Aerospace
- Government Suppliers
- IT
- Security Services
How Do Factoring Companies Make Money?
When a company factors its invoices, it means that it is selling its invoice to a factoring company and getting an advance payment equivalent to upto 90% of the total invoice amount. After the company’s customer pays the factor in full, the factor transfers the remaining invoice amount to the company and after deducting their factoring fee from it.
Depending on a borrower's credit profile, the applicable fee can range from 0.4% to 2% per month until the entire invoice is paid.
How do Factoring Companies Calculate their Fees?
The fees for factoring an invoice is calculated by applying the interest rate to the amount being advanced to the company against its invoice.
However, there are times when it can be charged against the total invoice. Depending on a borrower's credit profile, the applicable fee charges range from 0.4% to 2% per month until the entire invoice is paid.
For example, Ayaan Enterprises deals in electronics. A customer of theirs, Raj Ltd, purchases 10 television sets amounting to ₹10,00,000 with a payment period of 30 days. However, Ayaan Enterprises requires the cash urgently to fend off its expenses and seeks help from a factoring company. As per their contract, the factor advances 90% of the invoice amount to Ayaan Enterprises which amounts to ₹9,00,000 and the terms are 1% on the cash advanced for 30 days. After verifying Ayaan Enterprises’ invoice, the factor transfers ₹9,00,000 into the account. After 30 days, Raj Ltd pays the factoring company ₹10,00,000. The factor subtracts its fee of 1% or ₹9,000 of ₹9,00,000 and pays the balance of ₹91,000 to Ayaan Enterprises.
How are Factors Different From Banks?
Factoring is not a loan that companies take from factoring companies, instead it is a sale of assets (invoices) and therefore businesses are not subjected to debt. Therefore, whereas a bank is owed money by the borrower, a factor owes the customer the pending invoice amount.
Starting a bank can be much more difficult as banking is a strictly regulated industry, whereas factors are not very strictly regulated.
In a bank loan, the approval process of the loan can take longer whereas while seeking services from a factoring company, companies can receive a cash advance quickly.
The business needs to pay off its loan in a traditional bank whereas in a factoring company the business’ customer needs to pay off the invoice to the factoring company.
Risks Faced by Factoring Companies
There are certain risks faced by factoring companies due the uncertainties involved in international trade, such as:
Non-payment by Buyers After taking ownership of the invoices from a supplier, the buyer directly pays the factoring company. However, there may be some customers who are unable to pay the invoice amount to the factoring company. This becomes a bad debt for the factor.
Geopolitical Conditions Certain geopolitical situations such as terrorism or war that affect political and international relations can create problems for factoring companies. These conditions can impact the regulations and financial and operational stability of economies, financial institutions, as well as individual businesses, leading to financial and regulatory risks for factoring companies.
Currency Fluctuation In international trade operations, be it exporting or importing, significant fluctuations in currency exchange rates can create currency risks. Organizations or investors that have assets or run operations across international borders may be exposed to unpredictable shifts in currency values and due to such risks, a factoring company's repayment from the supplier's international customer can be affected.
What to Look for in a Factoring Company
When a company is looking for a factoring service provider to help bolster its cash influx, there are certain criteria that should be the deciding points -
1. Quick Service One of the main criteria that businesses should consider about a factoring company is the speed at which they can disburse cash. Businesses opt for factoring services to receive the invoice amount as early as possible to support their cash flow requirements. If this process is delayed, the need to factor invoices becomes redundant.
2.Contract Clauses Certain factoring companies wrap their clients in long-term contracts, which are expensive and uneasy for them to get out of. When getting into a contract with a factor, the business must see that the factoring companies provide transparency and include no hidden charges or terms.
3.Global Reputation If a factoring company does not have adequate global presence, it may not be able to offer solutions that can cater to the differences in invoice repayment norms in different countries. Also, if a business is engaged in international trading, it is essential for it to decide on a factoring partner that is flexible in accepting currencies from the different countries the business operates in.
4.Added Services While deciding on a factoring company to resolve their cash flow challenges, businesses should assess whether they can receive any additional services to facilitate their trade operations.
5.Advances Over and Above those Offered by Banks The services offered by banks and traditional factoring companies vary. If a business decides to opt for a factoring company rather than a bank, they should compare to check whether the invoice percentage offered by the factoring company is over and above the loan they might get from a bank. Based on this comparison, they can pick the most optimal source of financing.
You can learn more about factoring in finance here.
