After a credit sale is made by a business, it has certain expenses to pay off. However, due to the monetary crunch, businesses cannot boost their working capital.
To gain a monetary advance, businesses seek the help of a third party. This is when advance factoring services are utilized.
Meaning of Advance Factoring
Advance factoring is a type of factoring where the factor pays the business an advance on the value of the invoices sold.
The advance is typically a percentage of the invoice value, and the balance is paid to the company once the customer pays the invoice.
For example, a business sells an invoice for ₹2,00,000 to a factor with an advance of 80% with a fee of 2%.
This means the company would receive ₹1,60,000 upfront and the remaining ₹ 32,000 (after fee deduction) when the customer pays the invoice.
Purpose of Advance Factoring
The purpose of utilizing advance factoring are:
To meet the company’s short-term financial obligations
Useful for businesses having a high volume of invoices and facing delays in receiving payment from their customers.
To boost cash flow
Difference Between Advance Factoring and Prepayment
Prepayment and advance factoring are two types of financial instruments to manage cash flow and financing for a business.
They both involve the payment of funds before the delivery of goods or services, but they work in different ways and have different advantages and disadvantages.
Prepayment refers to the payment of goods or services before they are delivered.
This can be done by the customer or the business selling the goods or services.
Prepayment can be useful for companies that need to secure financing for producing goods or delivering services.
Customers can also use it to secure discounts or ensure they receive the necessary goods or services.
Advance factoring, also known as factoring with recourse, is a financial arrangement in which a company sells its invoices or accounts receivable to a third party (the factor) at a discounted rate.
The factor then advances a portion of the invoice value to the business, usually around 80%.
The factor is responsible for collecting the rest of the payment from the customer and repaying the rest to the firm minus the factor’s fee.
Advance factoring can help businesses to manage cash flow and access working capital, but it can also be expensive.
It may involve giving up control over the accounts receivable.
In summary, prepayment refers to the payment of goods or services before they are delivered.
At the same time, advance factoring involves selling accounts receivable to a third party at a discounted rate in exchange for an advance payment.
Both are useful for managing cash flow and financing, but they work differently.
Calculation of Advance Rate Advance rate is calculated by: Advance Amount x Factor’s Rate = Total Payback Amount The factor’s fee usually charges around 1-5% and depends on various factors such as the industry small business deals in, financial sheet, and monthly average credit sales.
Challenges Faced by Factoring Companies
Factoring companies, also known as factors, face several risks when financing businesses through purchasing accounts receivable. Some of these risks include:
- Credit Risk: Factors are exposed to credit risk when they purchase accounts receivable from a business.
If the customer fails to pay the invoice, the factor may not be able to recover the total amount owed.
Collection Risk: Factors are responsible for collecting payment from the customer on the purchased accounts receivable. If the factor cannot collect a payment, it may incur losses.
Fraud Risk: Factors may be exposed to fraud if the business selling the accounts receivable provides false or misleading information about the customer's creditworthiness or the quality of the goods or services sold.
Factors typically mitigate these risks through careful underwriting, credit analysis, and diversification of their portfolio.
However, these risks can still impact the profitability and stability of a factoring company.
