Factoring is a financing option where businesses sell their accounts receivable (invoices) to a third-party factoring company in exchange for immediate cash.
The factoring company then takes on the responsibility of collecting payment from the customers listed on the invoices.
Businesses often use factoring to improve their cash flow and manage their financial obligations.
The business receives a reduced amount of the total value of the invoices, usually around 80-90%, as the factoring company charges a fee for their services.
There are various types of factoring, and businesses can choose the one most suitable for them based on the exigencies of the businesses; factors like collateral, location of factoring, payment terms and the party getting paid are all aspects to consider.
Process of Factoring
The factoring process provides the business with an immediate influx of cash flow, allowing the factoring company to earn a profit by financing and collecting payment on behalf of the business.
This is done by:
1. Selecting invoices to factor: The business selects invoices they wish to sell to the factoring company.
2. Submitting invoices to factor: The business sends copies of the invoices and any relevant supporting documentation to the factoring company.
3. Evaluating invoices: The factoring company reviews the invoices to determine their creditworthiness and the amount they are willing to advance to the business.
4. Advancing cash to the business: The factoring company pays the business a portion of the invoice amount, typically 80-90%, in exchange for the right to collect payment from the customers listed on the invoices.
5. Collecting payments from customers: The factoring company takes on the responsibility of collecting payments from the customers listed on the invoices and applies the payments to the balance owed by the business.
6. Ensuring the remaining balance is received by the business: Once the factoring company has collected payment from the customers, they pay the remaining balance to the business minus any fees and charges.
Meaning of Conventional Factoring
Conventional factoring or full-service factoring is when the factoring company provides a full range of services, including credit analysis, invoicing, payment collection, and dispute resolution.
Businesses that need to increase their cash flow and swiftly receive payment for their invoices but lack the resources or capacity to handle the credit and collections process frequently employ this type of factoring.
It is typically more expensive than alternative forms of factoring, such as selective or spot factoring, but shifting the risk of non-payment to the factoring company, gives the business better financial security.
Services Provided by Factoring Companies
Factoring companies provide three primary services - financing, credit protection and administrative support.
a. Financial Services Financing is the most fundamental service offered by factoring companies. They buy a company's accounts receivable (invoices) and give the company a cash advance, usually between 80 to 90% of the invoice amount.
As a result, the business can get cash sooner than if they had to wait for their clients to pay the invoices.
b. Managerial Services Factoring firms offer their clients administrative support in billing, payment processing, and dispute settlement.
Instead of allocating time and resources to managing accounts receivable, this enables the company to concentrate on its core operations.
c. Credit Protection By taking on the duty of obtaining payment from the clients listed on the invoices, factoring companies offer credit protection to their clients.
This entails conducting credit checks on the clients and overseeing the collection procedure on the business' behalf.
Types of Factoring Solutions
Various types of factoring solutions can be leveraged according to the needs and wants of the business, such as:
Accounts Receivable Factoring
Accounts receivable factoring is a financial solution in which a small or medium-sized organization sells its accounts receivable or invoices to a factoring company in exchange for quick cash.
In addition to giving the firm an advance payment, the factoring company also takes on the duty of obtaining payment from the clients listed on the invoices.
A business can improve its financial stability and manage its cash flow more effectively by factoring its accounts receivable.
Read this guide to understand a detailed difference between accounts receivable and accounts payable.
Construction Factoring
Construction factoring is a type of accounts receivable factoring specifically designed for businesses in the construction industry.
The factoring company provides an advance payment to the construction company based on the value of its invoices.
The factoring company then assumes the responsibility of collecting payment from the customers listed on the invoices.
Construction factoring can benefit smaller construction companies that struggle to access traditional sources of financing.
It provides these companies with a flexible and cost-effective solution for managing their cash flow and ensuring they have the resources they need to finish their projects timely and within budget.
Credit Card Factoring
Credit card factoring, or credit card receivable factoring, is a financial solution in which a business sells its credit card receivables (sales made by customers using credit cards) to a factoring company in exchange for cash.
Credit card factoring can benefit businesses with extensive credit card sales and looking for a quick and convenient way to receive payment for those sales.
However, it can also be more expensive than traditional factoring, as the factoring company assumes the risk of non-payment by the customers and credit card companies and may charge a higher fee for this service.
Freight Factoring
Freight factoring is a financial service that provides trucking companies and owner-operators quick access to funds through the sale of their outstanding invoices.
Instead of waiting 30-90 days for payment from the consumer, small businesses get paid right away for the goods they have delivered.
The factoring company provides funding and handles the invoicing and collections process.
Invoice Factoring
Invoice factoring is a financial service that allows a business to receive immediate payment for their outstanding invoices instead of waiting for the payment from the customer.
In this process, the business sells its unpaid invoices to a factoring company, which provides an advance payment (usually 70-90% of the invoice value) to the business.
The factoring company then collects payment from the customer and retains a fee (typically a percentage of the invoice value) for their services.
Invoice factoring can be a beneficial source of operating capital for businesses, especially those with slow-paying clients or needing help with cash flow.
Non-Recourse Factoring
Non-recourse factoring is a type of invoice factoring where the factoring company assumes the credit risk associated with the invoices they purchase.
In this arrangement, if the customer does not pay the invoice, the factoring company is responsible for absorbing the loss, not the business that sold the invoice.
This reduces the risk for the company and gives them confidence that they will be paid for the invoices they have sold, regardless of the creditworthiness of their clients.
Non-recourse factoring is typically more expensive than recourse factoring, but it offers the business greater protection and security.
Learn more details about non-recourse factoring and how it is different from recourse factoring here.
Small Business Factoring
Small business factoring is a financial service that provides small businesses with quick access to funds through the sale of their outstanding invoices.
It is similar to traditional invoice factoring but specifically designed for small businesses.
It can be a useful alternative to conventional business loans for businesses that have difficulty securing traditional financing due to factors such as a lack of collateral or a less established credit history.
Spot Factoring
Spot factoring is a kind of invoice factoring that provides short-term, immediate funding for a single invoice or a small number of invoices.
Unlike traditional invoice factoring, which involves selling many invoices to a factoring company over an extended period, spot factoring provides a quick and flexible solution for businesses needing funds for a specific invoice or a small set of invoices.
The process is similar to traditional invoice factoring.
Spot factoring can be a useful solution for businesses that need to quickly access funds for a specific project or invoice without the commitment of a long-term factoring relationship.
FAQs
1. What is the First Thing to Do When Factoring? Selecting a trustworthy and knowledgeable factoring company is the first step in the factoring process. It's critical to consider aspects like costs, services provided, experience in the industry the business is in, and reputation when selecting a factoring company.
Reading reviews, comparing various factoring providers, and getting recommendations from other companies can help decision-making.
2. How Big is the US Factoring Market? The market size for the US factoring services globally was estimated to be worth USD 147.40 billion in 2021 and is projected to reach $153.96 billion in 2022.
3. Are Banks Allowed to Offer Factoring Services in the U.S? Yes, banks in the United States are allowed to offer factoring services. Factoring is a regulated financial service, and banks that provide factoring services must comply with relevant banking regulations and laws.