What Is Factoring and How Does it Work?

What Is Factoring?

Managing your business’s cash flow is essential to growing your business and meeting customer demands. Yet late invoice payments can sometimes make it challenging to purchase supplies, pay debts and maintain regular business operations. Finance factoring is an increasingly popular solution to this common challenge — Trade Finance Global found a 12.6% increase in factoring and receivables in 2021. 

Engaging in factoring means your business gains the benefits of immediate cash without spending time and resources pursuing payment from its customers and clients. Read on to learn more about finance factoring and how it can open opportunities for success. 

What Is Factoring? 

The definition of factoring is when a business sells its invoices — also known as accounts receivable — to another company for immediate cash or financing. A business might engage in finance factoring when it has short-term liquidity needs to meet, and its customers haven’t yet paid their invoices. Factoring in business allows the company to obtain cash immediately. They sell the accounts receivable to a third party who takes responsibility for settling the customers’ debt. 

Factoring accounts receivable is a faster way for indebted companies to receive their payments. Instead of waiting for their customers to pay their invoices, a company can sell them to a factoring business. In exchange, the company receives working capital to use for other purposes, such as completing a project or purchasing resources it needs to continue operations. 

Consider this example to demonstrate the meaning of factoring: 

  • A commercial property owner contracts a $1 million construction project from ABC Construction but leaves the invoice outstanding. 
  • Since ABC Construction needs the capital to begin another project and pay its subcontractors, it sells the invoice to a third party. 
  • ABC Construction receives an advance of $800,000 and the third party takes over pursuing payment on the invoice. 
  • Once the property owner pays the invoice, the third party pays ABC Construction the remaining balance minus its commission fees. 
Types of Factoring

Types of Factoring 

Businesses can engage in various types of factoring, including: 

  • Advance factoring: In this transaction, the third party pays a percentage of the accounts receivable to the indebted business before the customer pays the invoice. The third party pays the remaining balance upon receipt of the customer’s debt. 
  • Maturity factoring: In contrast to advance factoring, maturity factoring involves the third party paying the business on or after the invoice’s maturity. Both parties must agree on a date on which the third party will pay the total amount of the invoice. 
  • Recourse factoring: A recourse factoring arrangement requires the business to repurchase any accounts receivable from the third party where the customer fails to pay. 
  • Non-recourse factoring: In non-recourse factoring, the third party is responsible for covering any unpaid debts from the customer. 
  • Disclosed factoring: The invoice lists the third party in disclosed factoring, so the customer knows to pay the factor directly.
  • Undisclosed factoring: In undisclosed factoring, the invoice does not list the third party’s name. 

What Is a Factor? 

A factor in finance is the factoring business that buys other companies’ invoices, often at a discounted price. This third party purchases the accounts receivable and provides cash or financing. 

Factors are essential intermediaries between businesses and their customers. They function as a funding source so companies can continue their operations while waiting for customers to pay their invoices. Factors usually profit from the accounts receivable by buying them from the indebted company at a discount. The advance rates, discounts and terms of a factoring agreement vary depending on the factor’s policies. Commissions and fees also vary, though they are usually a small percentage. 

What Does a Factor Do? 

The factor provides several services in the factoring transaction: 

  • Cash flow: Factors buy invoices from businesses at a discounted price or for the total price minus their commission fees. The transaction provides the indebted company with immediate cash for its short-term needs, whether to pay its employees or continue its operations. 
  • Obtains payment from customers: When a business sells its invoices to a factor, that factor takes ownership of the accounts receivable. It’s then the factor’s responsibility to collect the funds from customers, freeing the business to spend more time on core business functions. 
  • Manages the sales ledger: The factor may also manage the sales ledger and keep track of transactions on the business’s behalf. 
  • Protects the business’s credit: By engaging a company in a non-recourse factoring agreement, the factor protects the business’s credit from the negative impact of invoice non-payment. 
Factoring Requirements

Factoring Requirements 

The requirements of a factoring agreement depend on the factor’s internal policies and procedures. However, businesses can expect to meet a few conditions before entering into most factoring agreements. Here are a few of the most common requirements for working with a factor: 

1. Business Identification Documents 

Before a factor agrees to work with your business, they will want you to provide several business identification documents. The documents you’ll need include your:

  • Articles of incorporation: Your business’s articles of incorporation are the documents that prove your business is legally documented. A factoring business wants to be sure that your company is legitimate. 
  • Business bank account: You’ll need your business bank account information so the factor can transfer funds into your account 
  • Tax identification number: A factor will use your business’s tax identification number to verify that it is up-to-date on tax payments. 

2. An Accounts Receivable Aging Report 

An accounts receivable aging report is another essential document. This report provides a complete list of your business’s unpaid invoices and how long they’ve been outstanding. An accounts receivable aging report indicates the amount of risk your business is under due to customer non-payment. Factors use this report to identify invoice amounts and due dates. 

3. Factoring Application 

Factors create factoring applications to gather essential information about your company, including its phone numbers, email addresses, industry and monthly volume of invoices. Factors use a factoring application to decide whether to work with your company and what rates to charge. Some factors specialize in one industry or prefer to work with businesses of a specific size. 

4. Invoices to Factor 

Factors work with companies with unpaid accounts receivable, so you need customers who are behind on payments before you can contract a factor. Be aware that some factors may require a minimum or maximum number of accounts receivable before they agree to work with your business.

5. Creditworthy Customers 

Factors also want to ensure that your customers will pay their invoices. If your customers are creditworthy, factors will feel like your invoices pose less risk. However, if you have a significant number of unpaid invoices from customers with poor credit, factors may be reluctant to sign an agreement with you. 

6. Paying the Factor’s Commission and Fees 

Finally, your business must agree to pay the commissions and fees the factor charges for its services. These fees and commissions enable factors to profit from the customer’s invoice payment. The factor’s cost may depend on your customers’ creditworthiness, your industry, your business’s sales volume and whether the factoring agreement is recourse or non-recourse. 

How Does Factoring Work?

Factoring works differently depending on the agreement between the business and the factor. For example, the factor will pay the company at a different point in an advance factoring process than it will in maturity factoring. However, the factoring process typically follows these steps: 

1. The Business Delivers an Invoice 

The first step in the factoring process is when a business invoices the customer for their purchase. While most of your customers probably pay their invoices on time, some won’t. 

Customers may have several reasons for not paying an invoice on time. Customers might not pay their invoices on time because: 

  • Their invoices go missing. 
  • Their invoices contain incorrect information. 
  • They have a poor accounts payable system. 
  • They have a billing dispute. 

Whatever the reason, unpaid invoices limit a business’s financial flexibility and can make factoring an excellent option.

2. The Factor and Business Enter a Factoring Agreement 

When the invoice is past due, the business may need additional short-term cash flow. That’s when it might decide to reach out to a factor and enter a factoring agreement. The factor and company will agree on the terms of their agreement, including the commissions and fees, factor rate and contract term. 

Factors need proof that a business has outstanding invoices before signing a factoring agreement, so companies must wait until they have invoices that need factoring. Once the parties have agreed to a fixed term for their business relationship and signed the factoring agreement, the factor will handle all outstanding invoices for the business. 

3. The Factor Purchases the Accounts Receivable 

The factor purchases the business’s accounts receivable, usually at a discounted price. The factor may pay between 70% and 95% of the total invoice amount, with the total cost depending on whether the parties agreed on advance or maturity factoring. 

The factor usually pays a larger percentage of the total invoice upfront. A factoring business may also withhold its commissions and fees upfront, depending on the type of factoring agreement made. 

4. The Customer Pays the Invoice Amount to the Factor 

The factor waits for the customer to pay the invoice amount. Before the customer can pay the funds, the business or factor must alert them that they owe the factor instead of the company that initially provided the goods or services. 

Factors may reach out to the customer after the business delivers the invoice. Alternatively, the business might disclose the factor’s information on the invoice if the company and factor are already in a factoring agreement. 

5. The Factor Delivers the Remaining Invoice Balance 

The last step in the factoring process is for the factor to pay the business the remaining invoice balance. If the factor didn’t withhold its commissions and fees upfront, it withholds them from this amount. 

In recourse factoring, if the customer delays paying the invoice until a specific date, the business must repurchase the accounts receivable from the factor, resulting in a financial loss. In contrast, non-recourse factoring places the financial responsibility of absorbing the unpaid invoice on the factor. In non-recourse factoring, the factor pays the invoice balance to the company and bears the risk of outstanding debts. 

Benefits of Factoring Your Invoices

Benefits of Factoring Your Invoices 

Using factoring to gain immediate financing for your business provides several benefits. Here are the top reasons why your company might consider engaging in factoring: 

1. Improves Cash Flow

The primary benefit of factoring your business’s invoices is receiving immediate funding to improve your cash flow. Factoring increases your business’s competitiveness by unlocking the funds tied up in unpaid invoices. Companies that use factoring can address their liquidity needs immediately instead of waiting for their customers to pay. Factoring can significantly improve your business’s short-term cash flow management. 

2. Mitigates Risk

Factoring in finance is an excellent way to mitigate some of your business’s risk. The immediate cash in hand from a factoring agreement enables companies to avoid defaulting on their loans. Businesses engaged in factoring can pay their creditors sooner than if they had to wait for their customers to pay invoices. 

Businesses can also mitigate risk through non-recourse factoring, transferring the risk of invoice default to the factoring business. In these factoring agreements, the factor accepts full responsibility for absorbing unpaid invoices, so the company doesn’t suffer if the customer never pays. 

3. Increases Efficiency 

Collecting funds from your business’s customers can be time-consuming and labor-intensive. Factoring improves business efficiency by saving businesses the need to pursue their customers for invoice payments. 

Instead of your company spending time and resources, the factoring business assumes responsibility for the accounts and pursues customers for payments. This way, the business is free to focus on business-critical operations or pursue new opportunities. 

4. Limits Reliance on Traditional Debt 

Businesses may consider taking out loans when they need immediate cash to meet their short-term liquidity needs. However, borrowing from a bank has some drawbacks. For example, a traditional loan might carry high compounding interest rates. In addition, the business is still responsible for repaying its loan even if its customers default on the invoice. 

Factoring offers an efficient alternative to traditional small business loans. Since the factor calculates its fees on the original amount the business borrows, factoring provides immediate cash without the burden of compound interest. Non-recourse factoring also frees businesses from the financial obligation of having unpaid invoices. 

Factor Your Company's Invoices With FactorFox

Factor Your Company’s Invoices With FactorFox

Companies in industries from health care to construction realize the advantages of factoring. At FactorFox, we offer intelligent factoring software and expert services to help your company obtain efficient solutions for its financing needs. 

FactorFox was the original cloud factoring software. We’ve carried forward our commitment to innovation to offer an all-in-one, secure factoring solution to help your business seamlessly manage cash flow. Our factoring services provide fast turnaround, advanced customer support and a growing list of features to meet your business’s unique needs. 

We deliver highly customizable software and ongoing support so you can get the most from our factoring solutions. Schedule a demo of our software today to see how FactorFox can help your business meet its financing needs. 

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