To expand their business operations rapidly, small businesses often tend to provide their products and services to their customers on credit, allowing their customers to buy now and pay later on a mutually agreed-upon date.
Sales made on credit often lead businesses to a crunch in their working capital.
To avoid the financial crunch while also offering favorable terms to customers, businesses can opt for factoring loans to ease their short-term financial distress using their unpaid invoices.
What is a Business Factoring Loan?
Business factoring loans are a financial source for small businesses to acquire immediate cash using their unpaid or outstanding invoices as collateral. Businesses accumulate unpaid invoices when they make a sale on credit.
These payments can be due from a minimum of 30 days to a maximum of 120 days, whatever is agreed between the business and the customer.
Many small businesses indulge in this practice because it helps them maintain healthy commercial relations with their customers.
However, this brings short-term financial strain on the business. During times like these, businesses opt for a factoring loan using their unpaid or outstanding invoices as collateral and agree to pay back the loan.
The factoring loan company verifies the invoices and immediately provides a portion of the unpaid invoice value as a loan.
In this type of loan, the business opting for a factoring loan maintains the legal ownership of its unpaid invoices, i.e it is the business’s responsibility to collect customer payments.
This is vital as this timely payment dictates the periodic repayments of loans.
How Does it Work?
Businesses opt toward a factoring loan service when they face a shortfall of cash in the immediate future.
This financial shortfall is sometimes caused due to businesses selling their products on credit or when they issue invoices with long payment deadlines, which allows customers to not pay immediately.
In this process, businesses use their unpaid or outstanding invoices, also known as account receivables, as collateral for the loan.
Before approving the factoring arrangement, the factoring loan company gets the business’s account receivables aging report.
This report generally showcases business clients and the amount they owe to the business, and the due date for the same.
The factoring loan company leverages the account receivables aging report to determine the amount to be provided as a loan.
The lender also verifies and confirms the unpaid invoices to be sure while lending the money.
Since the business is responsible for collecting its account receivables on time to pay back the loan, a failure to do so means that the lender can take ownership of those receivables and collect the final payment from the customers directly.
Example of Business Factoring Loan
A business faces a shortfall in its working capital. It approaches a lender to borrow money. The business uses its 50,000 INR worth of unpaid invoices as collateral for the loan.
The lender determines the lending amount using the business’s account receivables aging report and provides 80% of the amount.
The business then receives 40,000 INR from the lender immediately. Each month the invoice is past due, the lender imposes a 3% interest.
The customer manages to make the payment within the due date, i.e., within the month.
Therefore the business can keep 8,500 INR and provides a loan of 41,500 INR in return, which includes the original 40,000 INR with an interest of 1,500 INR.
Benefits of Factoring Loans
Opting for factoring loans in need of quick cash for businesses to ease their short-term financial strain has multiple benefits.
Quick Liquidity Factoring loan services allow businesses to receive cash quickly, especially when they struggle with their working capital. Additionally, this type of loan proves to be convenient for businesses that make sales on credit and have unpaid invoices with them.
Businesses can use these unpaid invoices or account receivables as collateral to get cash quickly.
Low Eligibility Requirements This type of loan will not have strict eligibility requirements for businesses to be able to get the loan, unlike other business loans. Therefore, its convenience helps it become one of the best loan options for small businesses.
Time-Saving Process The most important factor in a business is making the most of its invaluable resource, time.
Businesses can conveniently save time by opting for this type of loan as it has no strict eligibility criteria and fewer requirements to be able to acquire a loan.
Disadvantages of Factoring Loans
Factoring loans has its share of disadvantages as well. Reduced margins of profit, creditworthiness of customers, and loan repayment are a few disadvantages listed below.
Reduced Margins of Profit In essence, the factoring provider deducts a portion of each invoice. Even while it could only amount to one to three percent, organizations will still be losing money over time, which could have an impact on their monthly business budget.
Creditworthiness of Customers The factor's assessment of the customer's creditworthiness determines whether they can receive factoring or not. In case a customer’s creditworthiness does not match the factor’s requirements, the factoring procedure might not take place. Therefore, having customers with poor credit can be disadvantageous for the business opting for factoring.
Loan Repayment If a business opts toward factoring loans to ease their temporary financial hardships, they need to meet their payment obligations in a timely manner.
Failing to do so can lead third party financiers to confiscate the collateral used to obtain the loan. Here collateral used are outstanding invoices.
This means, the business can lose its invoice ownership if they fail to fulfill their payment obligations
How Does Factoring Differ from a Business Loan?
Factoring is a financial tool that businesses can opt for when they are facing issues with their working capital.
In the factoring process, businesses sell their outstanding invoices to a third party financier, known as a factor, at a discount in exchange for immediate cash. Whereas, in a typical business loan, a business needs to borrow funds using its assets as collateral.
In this process, a business is not selling up its assets to the funder but rather uses it as a collateral against the amount required.
Additionally, business loans will have a strict deadline for repayment of borrowed funds and will include multiple requirements and eligibility criteria that the business will have to fulfill before opting for a loan.
Whereas, in the factoring process, a factor has to verify and confirm the unpaid invoices which can be done quickly.
Furthermore, a business loan has a set amount of limit as to how much a business can borrow, whereas when it comes to factoring services, businesses can choose to factor as many account receivables as possible to ease their short-term financial crunch.
In short, the major difference between factoring and a business loan is that in opting for factoring services, a business typically sells its invoices to get the funding and in loan businesses usually borrows the money from the lender by not selling anything, instead they put up an asset as a collateral to get the funding.
Furthermore, in the factoring process, businesses lose the ownership of their assets whereas in a loan, they do not lose the ownership of their assets as long as they meet their loan payment obligations.
FAQs
How do you qualify for factoring? A business needs the following things to be able to qualify for a factoring process- an application for factoring, accounts receivables, aging report of those accounts receivables, required legal business documents, a business bank account, and clients with good credit.
Is factoring income taxable? Businesses must declare the money they get if they sell their outstanding invoices to a factoring company.
However, since a cash loan from a factoring company is not regarded as income, they will not be required to pay taxes if they keep possession of their accounts receivable.
Do you need good credit for factoring? Business’s creditworthiness is not the essential component in the factoring process.
However, customers need to have good credit as they will be responsible for making the final payment to the factor. Thus, even businesses that do not have good credit can opt for factoring.
