Finance 101 - 12.27.2016

Factoring 101: How It Works

For businesses with substantial accounts receivable (such as manufacturers, wholesalers, and B2B service providers), factoring can be an easy alternative to more traditional forms of debt.

What Is Factoring?

So what is factoring?

Strictly speaking, factoring is the sale of an account receivable (such as an invoice) to a third party at a discount. The company selling the invoice gets money today (discounted off the total invoice amount), and the company purchasing the invoice gets the full invoice value at a later date. It's a simple cash-flow management tool for companies with invoices on net-payment terms.

In practice, factoring can more generally refer to one of three types of transactions:

  • Invoice factoring. Invoice factoring is true factoring (outlined above)... the sale of an invoice at a discount. For instance, if you have a $100 invoice, you might sell it for $80.
  • Accounts receivable financing. AR financing is similar to factoring, except it involves borrowing against the value of a receivable, rather than the sale of that receivable. For instance, if you have a $100 invoice, you might borrow $80 and pledge that invoice as collateral.
  • Purchase order factoring. Purchase order factoring is a related form of relatively low-risk financing, wherein a business with a purchase order borrows money specifically to fulfill that purchase order, and typically secured by the proceeds thereof.

In all three cases, fees are typically assessed monthly.

How It Works

Factoring typically involves a two-part process: setup and funding.

First, you'll need to get your business setup with a factoring company. Typically, this process involves underwriting the business and reviewing your clients, which takes a couple of weeks. Once that process is complete, you'll be approved for a maximum amount you can factor (which may increase or decrease with your business's revenue), as well as what types of invoices you can use. You'll also setup the "lock box," the place to which your clients will make payment on your invoices (typically controlled by the factoring company).

Second, you'll send over qualifying invoices for approval and funding, which typically happens in a few business days. Expect to receive between 80 and 90 cents on the dollar initially. The remainder will be "rebated" to you when payment is made. All rebates are paid less processing fees (usually 3-5%) and factoring fees (usually between 1 and 5% per month).

Pros and Cons

Pros

  • Speed. Once you're setup, you can get money in as little as 3-5 business days.
  • Laxer Requirements. Approval is based upon how good your client's credit is, not necessarily your own credit rating. This makes it ideal for earlier stage companies.
  • Grows with You. There is potential for increased and continuous funding—factoring grows with your business.
  • Application Process. Factoring involves some underwriting, but you can expect less paperwork than a traditional small business term loan.

Cons

  • Less Regulated. Factoring isn't covered by lending laws, which means the terms tend to be less favorable than proper loans.
  • More Expensive. Factoring doesn't have an APR (interest) but typically, you only receive 80 to 90 percent of the value of the invoice.
  • Lock Box. Typically, factoring involves a lock box, where your customers send payment directly to the factoring company. Many customers are uneasy with this arrangement.
  • Limited Growth. Factoring will grow with your company, but not beyond. You'll always be limited to your invoices, which means it's not a great tool for growing your business.

Best Uses

Factoring is a great cash-flow management tool for businesses with lots of accounts receivable from established customers. It's not, however, a great tool for growing your business beyond your existing customer base, because you need the invoices before you can unlock the financing.

Summary

Factoring is the sale of invoices at a discount, and can sometimes refer to similar arrangements like accounts receivable financing and purchase order factoring. With factoring, you'll get your cash faster, but you'll get less of it. It's ideal for younger businesses or businesses with weaker credit profiles, but due to fees, it tends to be more expensive than other forms of financing.

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