What is factoring?
Factoring is a form of business financing. It is when a financial company purchases (ie. “pays off”) your business’s open invoices or outstanding balances from customers or clients. It may be because your customers are slow to pay, late to pay, or refusing to pay. Typically, a business will work with a financial company in order to improve cash flow now, rather than waiting the time it takes the customer to complete the payment.
A business can choose to have a financial company take care of only certain invoices. For instance, they may have the company take care of invoices that are due at later dates while taking care of upcoming invoices on their own. It all depends on the company’s immediate financial needs in terms of keeping the business running.
Recourse vs. Non-recourse factoring
There are two different types of factoring – recourse and non-recourse. Recourse factoring is when the business agrees with the financial company that they will ultimately take responsibility for the invoice if the customer refuses to pay after a set amount of time.
On the other hand, non-recourse factoring is when the financial company agrees to take responsibility for the invoice for better or worse. This means that the company is taking on credit risk as well as the possibility of no payment. As a result, non-recourse factoring agreements typically have higher rates.
Factoring vs. Traditional Bank Loans
Although factoring is a form of business financing, it works differently than traditional business loans. Compared to a business loan, here are key differences between factoring vs. traditional bank loans:
- Your company does not assume debt (ie. interest)
- There is no limit on the amount you can finance. The amount grows as you receive more customer invoices.
- It is not based on your business’s credit, but rather your customer’s credit.
- Rates can be adjusted as you finance more.
Which types of businesses use factoring?
Factoring is not limited to any particular industry or type of business. Both large and small companies choose to partner with factoring companies to boost their cash flow and invigorate their business operations.
Some common industries that take advantage of factoring are:
- Transportation and trucking
- Construction
- Staffing agencies
- Manufacturing and distribution companies
- Healthcare practices
- Oil and gas services
Why do companies choose to use factoring?
In short, when companies give their customers or clients time to pay their invoices, it causes a disruption in the company’s immediate cash flow. In other words, the company is short of the money owed for 30, 60, 90 or more days. As the company accumulates more clients who have open invoices, the amount of money the company is short can really add up.
Many companies simply can’t afford to be without that money for too long. They have salaries, employee benefits, rent, utilities, and many other operational costs to pay. Factoring these invoices gives the company the opportunity to retain both customers and cash flow at the same time.
How does it work?
The process of factoring invoices or debt is easier than it sounds. When partnering with a factoring company, you are essentially selling the company the financial rights to your open customer invoices. In return, the factoring company pays you immediately. Take a look at the process simplified:
- Your company delivers products/services to your customers/clients and issues invoices
- You partner with a financial company and send them your invoices
- The company gives you a cash advance (note: the cash advance depends on the company’s policy)
- The customer pays off their invoice to the financial company
- You receive payment (aka “rebate”) for the customer’s completed payment, minus a small fee (note: this fee amount depends on the company’s rates)
Note that since your company receives both a cash advance and rebate, you eventually make back what the customer would have paid you in their invoice. However, the financial company will receive a small fee for their services. So, all in all:
Advantage: Your company receives immediate payment for invoices, improving your cash flow.
Disadvantage: Ultimately, you will lose a portion of what you were owed by using factoring.
How much does factoring cost?
Different financial companies will have different fee structures. Some common fees that you can expect to see when partnering with financial companies are:
- Cash advance rates (~80%)
- Money transfer fees
- Collateral costs
- Overall factoring rate
Make sure you pay attention to the cash advance rate when you partner with a company. Normally, a factoring company will pay you around a 80% cash advance before receiving your customer’s payment, then a 20% rebate (minus their factoring fee) after receiving payment. Some factoring companies will give you a larger cash advance than others, which can impact your cash flow, so make sure to ask questions!
In terms of typical factoring rates, you can expect to see anywhere between 1-5% per 30 days (give or take). The time increment is determined by the company’s policies, your industry, and other criteria. For instance, some factoring companies will take into account your industry’s “risk factor” in terms of customers not paying.
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