The popularity of factoring has grown among companies looking to bridge their working capital gaps.

This guide will discuss the basics of factoring, the various parties involved, the expenses associated with it, the different forms it can take, and how Drip Capital helps American businesses with factoring solutions to bridge their working capital gaps.

Meaning of Factoring in Finance

Factoring is a financial method that allows businesses to access funds for growth, expansion, or fulfillment of their supply requirements.

It involves a finance provider purchasing or assuming the debt or unpaid invoice of the business or vendor.

The factor will then pay the invoice amount directly to themselves, typically at a reduced rate.

Factoring allows small businesses to acquire funds for ongoing operations, growth, and diversification.

It also serves as a useful means for exporters to release money that is tied up in the supply chain and improve their cash flow.

Additionally, when businesses sell their accounts receivable to the financier, the debt is also transferred, providing assurance of payment.

Process of Invoice Factoring

Here’s a summary of the invoice factoring process.

When a provider or vendor needs immediate funding and cannot wait for the payment to be received in the usual time frame, they turn to the factor.

The factor requests some basic information, such as personal identification documents like a passport, driver's license, or social security number, to evaluate the business history.

The factor reviews the financials, the quantity of shipments, and the buyer's past purchasing history and either approves or denies the application.

Once approved, the borrower can be registered on the factoring platform, where they can input the buyer's information and factor invoices as needed.

The factor will make a quick payment (usually 80-90% of the invoice) to the seller.

After the financing institution receives payment, any applicable charges are subtracted and sent to the seller.

Example of a Factoring Transaction

To make the concept of factoring more understandable, take the example of Chad Automotive Parts Ltd., which exports automobile accessories valued at $100,000 to Volkswagen Passenger Cars in Germany.

Under the terms of the agreement, the latter will pay $30,000 in advance, and the remaining balance will be paid over a period of time (usually 30, 60 or 90 days) when the order is delivered.

Thus, Chad Automotive Parts uses the initial payment to start the production process. Following the shipment of the products, the order is finalized; however, the business has to wait for an additional 15-30 days to receive the full payment. This lack of working capital can be a major difficulty for companies that are growing and need to manage other orders but do not have the budget for it.

Meanwhile, Chad Automotive has received a new request from Sky Motors, but they don't have sufficient money to secure the essential materials for production. Obtaining another loan from a bank is not a feasible alternative since the firm has already attained its credit cap.

In this circumstance, Chad Automotive can approach Drip Capital - a financial company - which can finance up to 90% of the pending bill, which amounts to $81,000 in total. When payment from Volkswagen Passenger Cars is due, Drip Capital will collect the money from them and, after subtracting the applicable fees, will send the leftover amount to Chad Automotive.

Types of Factoring

Factoring is a popular way of funding organizations, and there are distinct varieties of factoring depending on the particular necessities of a business.
Recourse Factoring

In this type of factoring, the obligation and danger of non-payment are assumed by the factor for a factored invoice.

Non-recourse Factoring

In this type of factoring, the credit risk and responsibility for non-payment are shouldered by the factor for a factored invoice. Learn about the differences between recourse and non-recourse factoring in this post.

Advance Factoring

The factor pays the vendor at a previously agreed upon rate of interest for yet-to-be-collected receivables.

Disclosed Factoring In this type of factoring, customers are conscious of the factoring agreement.

Undisclosed Factoring In this type of factoring, customers are unaware of the factoring agreement.

Maturity Factoring This type of factoring happens when the factor pays the seller after the invoice has reached its due date. Read this post for more details on advance and maturity factoring.

Invoice Factoring

This is the traditional form of factoring, where a business sells its receivables to the factor.

Domestic Factoring

This alludes to factoring transactions where both the purchaser and the merchant are based in the same nation.

Export Factoring

This sort of factoring may necessitate the inclusion of a third factor in the nation that imports.

Succeeding in export factoring necessitates an in-depth knowledge of global industries, a sound comprehension of international trade protocols, and the capability to release funds in various currencies. Working with a company that offers import-export financing solutions is one route to this.

Reverse Factoring

Reverse factoring refers to a financing agreement is initiated by the buyer to give vendors or suppliers early payment.

Check this finance guide for a complete explanation on types of financial factoring solutions in the U.S

Typical Costs in Factoring

When factoring, there are certain costs to take into account.

Interest Cost Interest cost is the amount that companies are advanced at a set rate.

This rate is based on the terms of repayment, the amount of the loan, and the borrower's credit history. Factoring interest rates typically range from 0.5% to 4% per month.

Processing Fee/Underwriting Fee Processing or underwriting fee is the fee paid to the factor for providing secured credit against an invoice. Factoring companies usually charge a flat fee or a percentage of the invoice amount for this cost.

Overdue Interest Overdue interest is applied to invoices that are past their due date, with a specific interest rate.

The factoring company begins calculating overdue interest payments after the due date has passed.

Learn more about the costs in factoring in this guide.

What is Factoring in Financial Risk?

Factoring in financial risk involves identifying and assessing the potential risks associated with a financial investment or transaction.

This can include assessing a borrower's creditworthiness, the potential for changes in interest rates or currency values, and other factors that could affect the return on the investment.

Factoring in financial risk is an important step in investment decision-making and can help investors make informed decisions that balance the potential returns with the potential risks.

Benefits and Drawbacks of Factoring

Financial factoring can be a valuable tool for growing businesses, but it also has certain limitations. Here are some advantages and disadvantages of factoring:

Benefits of Factoring

Speed: Compared to traditional business loans or bill discounting services, factoring does not require extensive paperwork and can provide funds to the borrower quickly.

Flexibility: Exporting firms have the ability to decide when to factor their invoices. Additionally, it is not necessary for them to factor all invoices from a single customer.

Credit Limits: Factoring is seen as an asset sale and not a loan. Companies can access this service in addition to their credit limits.

Drawbacks of Factoring

Cost: Factoring can be costly, but prices may be lower on account of long-term and recurring arrangements with factoring companies.

Reputation: A factoring company typically requests the issuance of a notice of assignment to the buyer, which poses an issue with some sellers or exporters as they cannot communicate with the buyers directly.

Why Would a Firm Choose Factoring Instead of a Loan?

A firm may choose factoring instead of a loan for several reasons:

Quick access to cash: Factoring allows a firm to quickly convert its accounts receivable into cash, which can be used to meet immediate cash flow needs.

This can be especially beneficial for firms with many accounts receivable but struggling to meet their cash flow needs.

No debt: Factoring is not a loan; it is the sale of assets (accounts receivable), so the company does not incur debt or have to pledge collateral.

This is beneficial for firms that may not qualify for a traditional loan or want to avoid taking on additional debt.

Creditworthiness is not a requirement: Factoring does not depend on the firm's creditworthiness.

Instead, the creditworthiness of the firm's customers is considered, which may be more favorable than the firm's creditworthiness. This can make factoring a more accessible option for firms with poor credit.

Flexibility: Factoring allows firms to factor in only the accounts receivable they need to convert to cash at any given time rather than borrowing a set amount.

This can provide firms with more control over their cash flow.

Factoring Solutions from Accounting Perspectives

Companies are required to document their factoring transactions in their balance sheet for the financial year.

They need to update the annual balance sheet with the original sale of receivables and the related accounting procedures, as well as calculate any associated factoring charges and sales deductions.

For example, consider company 'A' with an outstanding receivable of $100,000 wants to access funds. The company reaches out to a financier who grants their request and factors the receivables, along with a 1% fee and a 20% reserve of the total receivables.

The company is responsible for dealing with allowances, problems and shipping out products.

The factor ascertains the discounts on sales and charges the expenses of any accepted deductions in sales.

Therefore, the company receives $79,000 in cash and records a loss on sale of $1000 as the 1% financing fee.

Subsequently, the factor takes control of the receivable accounts, and the accountant transfers the receivables from the total amount of receivable accounts that have been sold to the factor entry.

The business will document 'Due from factor' as an asset depicting the reserve amount.

Finding a Good Factoring Solution

When searching for the right factoring option, companies should keep a few key considerations in mind:

Expertise in the Industry - Organizations should select a service provider with significant knowledge and understanding of their industry, and one that comprehends their business.

They should also be aware of the specific characteristics of the industry and the company's specific needs.

Flexibility - The factor should be clear about specific details, such as whether the business owner must sign a personal guarantee, whether they must sell their invoices, if factor invoices need to be provided for all customers, minimum invoice amount, any penalties for not meeting requirements, and maximum factored amount.

Customer service- A good factoring solution will always be responsive to its customers and attentive to their messages and emails. Businesses may have many questions regarding their liabilities and receivables.

They should confirm whether the factoring service provider assigns individual account managers or dedicated customer service departments for inquiries.

Stability- It is essential for organizations to make sure their financier is reliable and has a proven track record of success.

Costs - When factoring, businesses should be aware of the costs associated with it such as a flat fee or a percentage of the invoice amount based on its duration, fees for discounts, contractual obligations, average monthly transactions and others.

Also, they may need to be prepared for expenses like credit checks, legal paperwork and administrative tasks.

Therefore it is important for them to consider all these factors and choose the right factoring partner with care.

Is Factoring a Good Idea?

Factoring can be a valuable way for companies to improve their cash flow by unlocking money and tapping into supply chain finance.

Additionally, this type of financing is based on the sale of accounts receivable to financiers, which means that the sellers are not held responsible for the debt.

Factoring can reduce the risk of non-payment from customers as the factor assumes the risk of non-payment by the firm's customers, and the firm can continue its operations.

FAQs on Factoring

Is Factoring an Asset or Liability?

From the perspective of the company that is factoring its accounts receivable, it is considered a liability.

When a company sells its accounts receivable to a factoring company, it effectively takes on a liability to pay the factoring company the amount of the accounts receivable minus any fees and charges.

This is because the company is giving up ownership of the accounts receivable and is now obligated to pay back the factoring company in the future.

From the perspective of the factoring company, it is considered an asset.

The factoring company acquires the accounts receivable from the company and now owns them.

The factoring company now has the right to collect payments from the customers whose invoices were purchased.

How to Qualify for Factoring?

These are the general requirements to qualify for factoring:

  • Invoices to Factor
  • Personal Identification
  • Accounts Receivable
  • Creditworthy Customers
  • Completely Filled Factoring Application
  • Business Bank Account
  • Tax ID Number

How Many Invoices Can be Sold to Factors? The number of invoices that firms can offer to financiers may depend on the lender's policies. Some financiers necessitate that vendors factor in all their invoices for a month, while others permit them to select particular bills as required.

How long does a firm have to be in an agreement with a factor? Financiers have distinct contractual commitments. Some financiers necessitate a minimum of six to twelve months of the contractual period, while others may not.

When do Companies Obtain the Finances? Once a lender acquires an invoice, they usually give an initial amount (80%-90% of invoice value) immediately. Then, after taking away their fees, they pay the residual invoice value when the consumers settle the invoice total.