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Factoring is a way to quickly obtain working capital by selling your business’s outstanding invoices to a factoring company at a small discount. It allows companies to cope with an unexpected increase in payroll commitments, smooth out uneven cash flow, make it through a downturn or fund growth.
The big advantage of factoring is that it relies on the creditworthiness of the client, not your own. That makes it an ideal tool for newer companies that work with larger, more established clients and do not have access to traditional bank financing.
- The business provides a factor with a copy of the invoice that was sent to the client
- The factor verifies the invoice and runs a credit check on that client
- The factor advances a portion of the outstanding amount
- Once the invoice is paid, the business gets the remainder minus the discount rate and any additional fees
The advance rate depends on the industry, your client’s creditworthiness, how many invoices the business is looking to factor and their dollar amount, among other things. The typical range is between 70% and 96%.
For example, a retail supplier might get $7,000 on a $10,000 invoice – a 70% advance – due to the higher likelihood of their counterparty returning unsold product, especially in consignment-based arrangements. At the same time, a trucking or a labor staffing deal might get $9,600 on a $10,000 invoice – an advance of 96% – because these types of invoices are harder to challenge.
In certain situations, the factor may also hold back a percentage of the invoice as a reserve until the customer pays. It is more likely that a reserve will be held wherever a physical product is concerned or whenever the customer (debtor) is a retailer, is located in another country or whenever the majority of the value being invoiced is for something other than labor. The reserve covers short payments, credit memos, inaccurate billing amounts, disputes between the customer (debtor) and the client, etc.
Once the invoice is paid, the factor pays back the reserve, minus certain fees. The fees are not uniform across the industry and depend on the type of arrangement. In recourse factoring, for instance, if after a specified period the lender is not able to collect on the invoice, the onus is on the borrower to either pay the bad invoice or replace it with a “good” one. Conversely, in a non-recourse factoring situation (https://businessfactors.com/types/non-recourse-factoring/), the factor becomes the payee of invoice and there is no chargeback to the client if the former is not able to collect.
Below are two examples of how a deal might be structured on a $10,000 invoice with an 85% advance rate.
- Invoice amount: $10,000
- Advance rate: 85%
- Reserve: $1,500
- Discount rate: Flat fee of 3% for the duration of the arrangement
- Type of arrangement: Full recourse after 60 days
In this scenario, the client would only pay a one-time fee of $300 but would have the invoice charged back to her if the counterparty does not pay within 2 months.
- Invoice amount: $10,000
- Advance rate: 85%
- Reserve: $1,500
- Discount rate: 3% per month until the invoice is collected; fee capped at the reserve amount
- Type of arrangement: non-recourse
In this scenario, the factoring company is responsible for collecting on the invoice but, the longer it is unable to do so, the more the client pays. So if the invoice is outstanding for 3 months, the client would pay $900. However, if the collection takes a year, the maximum the client would pay would be $1,500.
Other fees that a factor may charge include costs associated with due diligence, monthly minimums, termination, among others.
The above are just some of the ways in which a deal can be structured. The reason why factoring is a popular solution to avoid cash crunches is that it is a highly flexible and creative way to obtain working capital, without succumbing to the restrictions associated with traditional bank financing. For instance, small business invoice factoring does not increase leverage. It typically requires little paperwork and has a fast, 24-to-48-hour turnaround. Factoring companies don’t place restrictions on the use of proceeds. Bank loans on the other hand, often can only be used for the specific purpose they are provided for and contain covenants, which can limit the incurrence of additional debt, ability to make acquisitions and mandate EBITDA and interest coverage levels, to name a few.
Factoring allows businesses to shorten their working capital cycle and is suitable for companies across different industries and in various stages of growth, from startup to mature companies.
It helps businesses to take on new projects and grow earnings. Say, a construction company is offered $20,000 on a last-minute project but has to buy $15,000 of supplies upfront. The cost of the supplies can be financed by factoring a $15,000 invoice for 4 weeks at 1% per week as shown below.
|Factor accounts receivable||Do nothing|
|Potential gross profit||$5,000||$0|
|Less cost of factoring||$600||$0|
As demonstrated, by choosing not to sell an invoice, the business loses out on an opportunity to earn $4,400.
Factoring allows small businesses to free up funds that can be used for other projects without having to wait for 30 to 60 days for client’s invoices to be paid. Invoices can be factored on a one-off basis – often referred to as ”spot factoring” – or under an agreement that requires the business to submit all of its invoices (“whole ledger” factoring).
When looking for the right factoring company for your business, make sure you understand the fees charged by the factor, consider your needs and keep in mind that these arrangements are often more flexible than traditional bank financing.
Apply online or learn more about Small Business Factoring:
- How a Factoring Company Can Help Your Small Business Grow
- Managing Small Business Growth
- 3 Alternative Financing Options For Your Small Business
- Lesser Known Small Business Financing Options for Veterans
- Factoring Company vs Banks: Which is Better for Small Businesses
Factoring Specialties Available at Business Factors: