Factoring

Factoring helps a business access cash right away instead of waiting for customers to pay.

“Factoring can help businesses manage cash flow, invest to fulfill new orders and streamline collection,” says Renaud Ponton, a CPA and Business Advisor with BDC Advisory Services.

“For example, if you receive large payments only at the end of key project milestones, you may find factoring helpful for managing your running project costs.”

Factoring is more common in Europe where businesses often use it to manage cash flow instead of using a line of credit. “In North America, factoring is less common, and businesses tend to rely more on lines of credit to manage cash flow,” Ponton says.

What is factoring?

Factoring is a financial transaction in which a company sells its accounts receivable in exchange for immediate funds. Factoring is offered by firms called factoring companies and some banks (though not BDC), which may collect the accounts receivables directly from customers in exchange for a fee.

There are other models as well. For example, the factoring company may charge a fee for assuming the risk of non-payment (in which case the client may still collect their own accounts receivable). 

The process is also sometimes known as invoice factoring. A business may factor any of the following:

• one or more invoices
• one or more clients
• some combination of the above
• all its accounts receivables

A business may also factor for specific purposes—for example, to meet payroll obligations by receiving an advance on outstanding invoices. 

To explain how factoring works, Ponton gives the example of ABC Co. that has just delivered on a contract worth $1 million and sent its invoice. The customer is a large, financially stable firm, but it typically waits 90 days to pay invoices. ABC Co. needs the funds now to buy the inputs it needs to work on new orders. It decides to sell the $1 million receivable to a factoring company. 

The factoring company agrees to give ABC Co. an advance and may withhold some percentage of the receivable. The factoring company then deals with the customer to get paid. Once the customer sends the $1 million, the factoring firm then releases the remaining balance to ABC Co., minus a discount. 

This is just one example of a factoring scenario. Factoring companies offer different terms and conditions, so it`s important to compare options to find the best fit for you.

The factoring firm sets its factoring rates after thoroughly reviewing the risk profile of the transaction, including: 

• the credit quality of the company and customers
• invoice amount
• industry risk profile

Why would a business use factoring?

Businesses use factoring for several reasons.

Managing cash flow

Factoring can help manage cash flow, especially if the firm has slow-paying clients or short-term financial needs. It can also help businesses with irregular and unpredictable cash cycles, such as seasonal or project-based companies or those that rely on a few key clients.

Ponton gives the example of a company that gets a large new client that pays very slowly. “They’re going to pay, but it’s going to take a long time and it will mess up your cash flow,” he says. “You can factor just that new client and keep collecting all your other existing customers yourself.”

Investing in growth

Factoring injects immediate funds that may be needed to invest in raw materials or other inputs required to fulfill new orders.

Simplifying collection

It allows a company with limited internal capacity to outsource accounts receivable collection and maintain a tighter grip on accounts receivables, in circumstances when internal collection staff are not available to do it.

Mitigating collection risks

Factoring allows you to rest easy that you’ll get at least most of the money you’re owed no matter what.

Before agreeing to any factoring contract, Ponton advises entrepreneurs to carefully review the advance and factoring fees and other costs to see if it’s a good idea for your business. “There has to be a business case,” Ponton says. “When you know all the fees, you can analyze the cost-benefit and see if it’s better to collect internally or not. Sometimes it can be more profitable to go this way.”

What kind of companies use factoring?

Any kind of company can use factoring, but it can be especially helpful for manufacturers and other businesses that need to invest upfront in raw material and other items to fulfill orders with customers that tend to pay slowly.

Ponton gives the example of a manufacturer of high-end products for customers that typically pay in 60 days. “You need to buy raw material to produce the products, and to get the best deal you may need to pay cash on delivery,” he says. “Your account payable is zero days, but then you need to make the product and the client will take 60 days to pay you. There may be 120-day gap between these two things.

“Factoring can help ensure your account payables and receivables are more aligned.”

Who collects the invoices in factoring?

In most cases, the factoring company collects the accounts receivable, not the client. “This is one of the main advantages of using factoring,” Ponton says. 

“It’s out of your hands. You don’t have to deal with that anymore. The customer pays directly to the factoring company.” 

This is not always the case, however. Sometimes, the client will continue to collect on their accounts receivable while the factoring company mitigates the risk of non-payment. Other options may also be available.

What are typical fees paid for factoring?

Factoring fees can vary depending on several factors, including the industry, the volume of transactions and the specific terms. 

Typical fees may include:

• the factoring rate (a percentage of the invoice value)
• other fees, such as setup, monthly minimums and service charges
• advance rates (a percentage of the invoice value that is advanced to you)
• flat-fee structures, which can help simplify the cost structure for you

The advance and factoring rates and various fees vary depending on the creditworthiness of your business and customers, the amount of receivables and industry risks.

What are the advantages of factoring?

Factoring offers several benefits. These include:

• freeing up liquidity
• handing off invoice collection to someone else
• reducing non-payment risks
• managing your indebtedness ratios (versus using credit lines)

What are the disadvantages of factoring?

The main disadvantage of factoring can be the cost. This may be significant if the factoring company believes there is an elevated risk that your customers won’t pay. You will need to evaluate the costs associated with factoring versus the costs and risks of collecting on your own. 

Alternatives to factoring

Businesses have several alternatives to factoring. These include:

A line of credit

A credit line is a short-term loan that a business can tap to borrow up to a pre-set amount. It is generally secured by the company’s inventory and accounts receivable.

“A line of credit is the most popular financing product for short-term needs,” Ponton says. “It’s flexible and usually a very good tool to bridge your accounts payable and accounts receivable.”

Purchase order (PO) financing

PO financing is a loan typically secured by the purchase order itself. It is usually obtained after a purchase order is signed and paid back when the customer pays the invoice.

PO financing differs from factoring in several ways. The former is a loan, whereas factoring is not. PO financing is granted when a purchase order is signed, while factoring occurs after the customer has received the goods.

Improve your cash conversion cycle

Another alternative to reduce the need for factoring is to improve your cash conversion cycle—the amount of time it takes to convert investments in inventory into cash.

You can do this by reducing how long items sit in inventory, speeding up collection of accounts receivable and taking more time to pay suppliers—while being sure to maintain good relations with all your partners. Such steps can improve your company’s cash flow and financial performance.

Increase internal capacity

Hiring a bookkeeper or otherwise increasing your internal capacity could make invoice collection more efficient and reduce the need to turn to factoring.

Factoring versus bank loans

Factoring is not a loan. It is typically the sale of your accounts receivable at a discount to get cash right away. On the other hand, a loan is money that a lender gives a business with the agreement that it is paid back over time. 

Businesses sometimes prefer to factor their accounts receivable instead of getting a loan because the latter can affect their financial ratios. 

“Factoring can be a useful short-term solution,” Ponton says. “But if you have a series of large long-term contracts, a long-term loan may be a more dependable solution for ensuring you have the funds you need to operate or grow your business.”