The order is fulfilled, and the invoice is generated, but the funds simply don’t appear in the business account. Customers who delay or don’t make payments can be frustrated and create additional work. In the most severe scenarios, overdue payments can even jeopardize the company’s survival. Factoring companies present a solution: They purchase a company’s outstanding invoices. However, how does this process of factoring precisely function? And is this form of financing suitable for your business?
What Is Factoring In Financing?
Factoring materializes when a company transfers its owed payments to a third party. The fundamental concept involves selling pending receivables to a financial intermediary, commonly referred to as a factor. This approach ensures that the company obtains its liquidity in a predictable and timely manner.
How Does Factoring Work Exactly?
Let’s consider Company X, which fulfills an order for its corporate client, Company Y, resulting in a service charge of $200,000. Company X then transfers this outstanding payment to a factoring firm. In turn, the factoring company swiftly disburses the amount to Company X – generally within a 24-hour period – and subsequently collects it from Company Y. The factoring provider receives compensation for this service.
Subsequently, Company Y submits the $200,000 payment to the factoring company. If this doesn’t occur, the factor often manages the reminder process or takes on the risk in case payment is overlooked.
What Are The Advantages Of Factoring?
The detailed overview of factoring’s advantages will help you to grasp the significant benefits it can bring to your business. Understanding these will empower you to determine if factoring aligns with your financial goals and requirements.
Enhanced Liquidity:
Most medium-sized enterprises that opt for factoring are primarily focused on bolstering their liquidity. The advantage is clear: Rather than waiting for weeks or even months until clients settle their payments, factoring ensures immediate access to funds. Given that the factor assumes responsibility for a company’s pending debts, greater financial flexibility is attainable. This could translate to obtaining more significant discounts due to early bill settlements. Conversely, businesses can extend payment deadlines to clients.
Risk Protection:
Generally, a factoring provider also absorbs the risk of uncollectible debts: If a customer declares bankruptcy or neglects an outstanding invoice, the company still receives compensation. Alternatively, safeguarding against default risk can be achieved through trade credit insurance. Yet, in contrast to factoring, this approach has the drawback of delayed fund availability. Insurance companies require more time to provide compensation for lost receivables. Factors usually decrease their risk exposure by conducting credit assessments of your clientele in advance.
Enhanced Rating:
Factoring enables companies to optimize their balance sheet structure: With default protection from the factoring company, receivables can be removed from the balance sheet. This eliminates risk and boosts your equity ratio. This enhances your rating and, subsequently, your company’s creditworthiness.
Reduced Workload:
Upon your preference, the factoring company can oversee all outstanding debts. This encompasses invoice and reminder issuance, along with monitoring fund receipts. By embracing factoring, you can even partially outsource receivables management from your accounting department, streamlining accounts receivable management. This trims time, effort, and expenses.
What Are The Disadvantages Of Factoring?
While factoring offers numerous benefits, it’s essential to understand its potential drawbacks. Exploring these disadvantages will help you make an informed decision about whether factoring is the right financial solution for your company.
Limitations:
Factoring isn’t universally applicable. Industries like manufacturing and related wholesaling can leverage it to secure outstanding debts. However, challenges arise in the realm of services. Factoring companies accept such debts only if well-defined. This means project orders like engineering or architectural structures can’t be secured via factoring.
When the invoice is issued, the service must have already been provided. If this is not the case, purchasing the invoices is not possible. In every industry, there are business models for which factoring is not an option for this reason. Factoring providers also only insure claims against private customers in exceptional cases. Retailers can therefore hardly resort to this financing instrument.
Extra Expenses:
Out of pure human kindness, no factoring institute takes over the outstanding debts. The factor charges a fee for its services that depends on sales, risk, and workload. In most cases, there is also a flat rate for a possible credit check for your customers. In addition, interest is charged on the liquidity provided, similar to a loan from the bank. However, this would require additional security.
How Much Does Factoring Cost?
The costs for factoring are usually between 0.6% and 2.5% of the purchased receivables. What exactly factoring costs depends on the provider and the specific service: Does the factoring company only take on the financing and the risk – or also the dunning process? Of course, this also affects the price.
The order volume also plays a role in pricing: the more money the factor makes with a corporate customer, the cheaper the factor can calculate its price. The industry and creditworthiness of the company that wants to use factoring also play a role: From the factor’s perspective, the greatest risk of default is on the customer’s side – and not with individually purchased invoices.
So what does that mean specifically? A factor may be satisfied with a factoring fee of 0.1 percent, explains the financial expert. For a small company with major production uncertainties, the fee would perhaps be closer to three or even four percent. In addition, there is interest on the money that the factoring provider has to borrow for the period between the purchase of the receivables and the receipt of payment.
What Types Of Factoring Are There?
Different factoring variants enable financing depending on the needs of the company.
Full-Service Factoring:
The process is also called standard factoring. The factor finances the receivables and bears the risk in the event that the debtor cannot pay. In addition, customers are largely relieved of debtor management. This means that the factoring company handles all of the invoicing for the customer and also sends reminders. This is particularly useful for small and medium-sized companies without a large accounting department of their own.
In-House Factoring:
This variant – also called self-service factoring or bulk factoring – is used for financing and risk protection by the factoring company. Administrative tasks such as debtor management and dunning remain with the company that assigns its claims. She continues to ensure that the customer pays – as a trustee of the factor, so to speak. This advances the money and steps in if the debtor defaults. This model is particularly suitable for large companies.
Due Date Factoring:
Another type of option is due date factoring. With this variant, the entrepreneur uses the advantages of risk protection and relief from debtor management but foregoes the immediate regulation of the purchase price, i.e. the financing effect of factoring. It is primarily about outsourcing accounting work. This form makes the customer’s financial planning easier, as specific payment dates can be agreed with the factor, regardless of the debtors’ payments. However, this variant rarely occurs in practice.
Real/Fake Factoring:
If the factor assumes the company’s risk of default, this is referred to as genuine factoring – with spurious factoring, this risk is not assumed. This is not a real purchase on account, but rather a form of pre-financing, which does not relieve the burden on the company’s balance sheet. Everywhere real factoring has been practiced almost without exception for years.
Open/Silent Factoring:
With silent factoring, the service provider stays in the background and sends invoices and reminders on behalf of the company that commissioned them. With open factoring, the service provider appears to the end customer: they are informed about the sale of the receivables and asked to pay directly to the factor. This can certainly be desirable: “You often want a third party to appear in the dunning process in order to give the demands more emphasis,” says Kahlcke. In this country, open assignment is predominantly practiced.
Bottom Line
Until a few years ago, factoring was primarily a form of financing for large companies. Many factoring companies only bought invoices if a certain minimum amount was reached each year. But that has changed: There are now numerous providers who also offer offers to small companies and even the self-employed.
You can calculate for yourself whether factoring is worthwhile for you: From the perspective of the factoring customer, the markup for the service should always be lower than the discount that he grants his customers. You may also be able to use the liquidity gained in this way to receive discounts on purchases yourself. Factoring also pays off more quickly.
Which factoring model is right for you depends entirely on the company. For companies that already have good accounts receivable management, the in-house method is an option. However, for companies that have a turnover of less than 10 million dollars per year, full-service factoring is usually the better solution because the effort involved is significantly lower.
In principle, factoring is suitable for companies with a broadly diversified customer base, with standardized products or services and manageable payment terms. Such companies receive better conditions from factoring companies than companies that depend on a few buyers.