You may have heard the word “factoring” before but you aren’t quite sure what it means. Factoring or “factors” are third parties that provide financing to businesses by buying their accounts receivable (AR) on consignment. In simpler terms, if you have ever purchased a car, you know that the dealership takes your check, adds a fee and gives you the rest of the money. This fee is called a factor. Factoring is essentially the same process, except it applies to other businesses such as wholesalers, manufacturers, distributors and service providers. The biggest advantage of factoring is it enables your business to grow faster because cash isn’t tied up in unsold inventory or invoices waiting to be collected.
How Does Factoring Work?
The factoring company purchases the right to collect uncollected debts owed to your business. They then collect those debts and place the funds in a trust account. The factoring company will then apply the money to the accounts payable balance on your account while a promissory note is established to repay that amount plus interest. Once the factor has verified that you have collected the receivables, they will release the funds to your business. Factoring is also referred to as asset-based lending. The factor will lend your business money based on the value of your accounts receivable. The factor will calculate the amount of money they will lend you based on the average amount of days for collections for your business. Once you factor your AR, you’ll receive an advance on the amount the factor will pay you for those AR.
Why Should You Care About Factoring?
The main advantage of factoring is that it allows you to generate cash from your AR without having to wait for the customers to pay you. While credit customers are generally prompt in paying, you may have a situation where an important customer has been affected by a natural disaster and is not able to pay you on time. If you have not collected the invoice and need to use the money, you may have to wait a long time until they do pay you. Factoring allows you to collect the money immediately and use that money to run your business. Moreover, you can factor all your AR, even if you have a few slow-paying customers. If you have to wait for all the invoices to be paid, you may find that you have run out of cash while waiting for those payments.
Advantages of Factoring
– Immediate cash flow – If you have to wait for your customers to pay you, it could take months before the money is in your account. With factoring, you receive a cash advance on the value of your uncollected invoices. This cash can be used immediately to grow your business. – No or minimal credit check – A factor does not conduct a credit check on you as they are not loaning you money but are buying your AR. If you don’t have the credit for a loan, you may be able to factor your AR and get the cash you need to grow your business. – No collateral required – Some banks may require you to post collateral or give you a loan with a high interest rate. A factor doesn’t require collateral, and they often have lower interest rates than banks. – No impact on your credit score – When you borrow money from a bank, your credit score may be negatively impacted. If you factor your AR, the factor will not check your credit. – No or minimal security – If you borrow from a bank, you may be required to post collateral such as real estate or inventory. If you factor your AR, you may not need to provide any security.
Disadvantages of Factoring
– No interest savings – If you borrow money from a bank, you can negotiate a low interest rate as you have collateral. When you factor, there is no interest savings. – Higher cost than bank debt – Although factoring has lower interest rates than bank debt, the upfront fees are higher. When you factor, you must pay a factoring commission, a service charge and a discount rate. – No repayment flexibility – If you borrow money from a bank, you can repay the loan over a period of time. When you factor your AR, you must repay the factor within 90 days. – May reduce your cash flow – When you factor your AR, you must repay the factor when you receive the next payment from your customers. If you have a slow-paying customer, you may not receive the payment until after the due date for the factor. You may have to borrow money to pay the factor until you receive the next payment from your customer.
Final words – Is factoring right for your business?
As you can see, factoring can be a useful tool to help your business grow. You can use the money to purchase additional inventory or to hire employees. However, you should carefully review the advantages and disadvantages of factoring to make sure it’s the right decision for your business. We can help you make this decision, Start a new application today and lets us help you using the start application on this link