How Factoring Works
Factoring is the sale of invoices or Accounts Receivable at a discount.
It is a way for the business to generate cash and improve cash flow without
taking on additional debt.
Traditionally, factoring was a financing service used by the textile and
furniture industries. Today however, factoring has become a financing standard
in just about any industry that created Accounts Receivable by extending
terms to its customers.
Why do companies factor their Accounts Receivable?
Simply put, to generate cash flow. Factoring provides immediate working
capital for companies facing a short term cash constraint. Most companies
that choose factoring are not currently able to qualify for a traditional
loan from their bank or companies who are growing faster than their bank
is willing to extend credit. Due to credit policies and regulatory constraints,
banks typically need to see 2 years of profits, minimal leverage and a certain
amount of cash flow for debt coverage. A company that does not meet these
characteristics and does not have any real estate to pledge as collateral
can many times find itself on the outside looking in.
However, companies with Accounts Receivable (a current asset but not cash)
can use them to generate cash for their day to day working capital needs.
How does Factoring work?
When a company sells its product or service on terms, it typically creates
an invoice. This outstanding invoice for completed work can be called an
Accounts Receivable. Instead of waiting to receive the cash when the customer
remits payment, the business may decide to factor the receivable and immediately
receive the cash. In order to have instant access to funds, the company
is charged a nominal fee.
To begin the factoring process, the company identifies the invoice(s) to
be factored. The Factoring company will then typically verify the invoice
with the customer and advance a percentage of the invoice (usually 80% to
90%). The remaining 10% to 20% is held in the Reserve Account. Payment from
the customer is then directed to a designated lockbox. Although the check
from the customer is still made payable to the company, the remittance address
will change so that payment goes directly to the Factoring company. Once
payment is received the Reserve Amount is rebated to the company minus the
fee.
As the company generates more business and creates more invoices, the process
begins again.
What are the benefits of Factoring?
Although every business is different and their reasons for Factoring may
not be the same, the following benefits are representative of most situations:
- Additional cash is immediately available
- Quick and easy to set up
- It is temporary (no long term contracts required) and flexible (frequency and amount of funding is optional)
- No additional debt is created as it is "Off Balance Sheet" financing
- Owner avoids giving up equity or control of the company
- Unlimited source of Working Capital - the funds available grows as the company's sales grow