Invoice factoring is a tool used by businesses at all levels to increase their cash flow yet not increase their debt service. In the factoring process, a business sells its receivable invoices at less than face value, which is known as the discount rate, to a business known as a factor. The factor then proceeds with the collection process. Discount rates vary as do procedures. Some factors may pay the entire discounted price up front and proceed to collect on the debt. Others may make a partial payment of the discounted price and pay the balance owing at the time the funds are collected.
Factors purchase quantities of receivables at a discounted rate, which varies depending on the quality of the receivable. For example, a batch of receivables from AAA-rated companies will require less of a discount than a batch of receivables from B-rated companies because there is less risk of default from higher rated companies.
Since factoring is predicated on the invoiced customer’s credit rating rather than the credit rating of the business owning the debt, a creditor can receive immediate cash for a receivable without regard to his or her credit rating.
The following is the simplified process of factoring:
- Business A buys goods on credit from Business B, thereby creating a receivable for Business B.
- Business B contacts Business C, who is a factor.
- Business C purchases the receivable from Business B.
- Business B now has additional immediate cash flow but has not incurred additional debt.
- Business C collects the monies due on the receivable created by Business A.
The factor profits from the transaction because of the discount rate. For example, a factor may purchase an invoice with a collectable value of $1,000 but pay $750 for it. The $250 would be the profit for the factor, less the cost of collection. The factor does not have to spend resources to generate income, only to collect it. The business, in other words, the owner of the invoice, incurs the cost of generating additional income, but does not incur collection costs.
In other words, invoice factoring is essentially the same as outsourcing collections but with the advantage that cash flow is increased immediately rather than at the time of collection.
The Financial Benefits of Factoring
Particularly in a sluggish economy, cash flow for businesses can be difficult to generate because debtors may be slow to pay their invoices. In addition, credit usually tightens during sluggish economic conditions, so business loans may be difficult to obtain.
By using factoring as an income-generating tool, a business can immediately increase its cash flow without having to wait for loan approval and without having to increase its debt service. Particularly for businesses whose credit rating may have suffered due to economic conditions, factoring can be significantly advantageous.
Factored funds, used wisely, can more than pay for the cost of the discount rate. For instance, factored funds can be applied to business expansion, which will increase the customer base, which will generate more income and therefore more profit. As well, the funds can be used to procure additional inventory so that goods are delivered more quickly to the customer, thereby increasing good will and business reputation.
Factored invoices can be used to cover payroll, payroll taxes or other daily operating expenses that may arise. Factored funds can also be used to cover the cost of equipment repair, replacement or upgrade.
Since debt collecting can become a convoluted process and laws governing debt collection vary widely, using a factor can be very advantageous, particularly for a small business that lacks a legal division. Factors are professionals at collecting on invoices and may have a better success rate at collecting from slow-paying customers. In addition, the factor is responsible for adhering to state and federal collection laws which may eliminate liability for the original owner of the debt.
A growing trend in the factoring business is to offer consultant services, such as business planning and advice, to their factoring clients.
Although factoring can be costly for some receivables, it is an excellent method for a business to quickly obtain financing for a project or to increase its cash flow when other avenues of credit may be unavailable.
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Thanks for explaining invoice financing. It’s a little known tool that businesses need to know about. What I like about it is that they don’t have to shell out money to pay interest — it’s money they already earned albeit at a discount.
I want to caution businesses that look into invoice financing — to do their due diligence. Just like different banks offer different loan options — factors have different options and fees.
It needs further investment and skills to sell their receivable invoices so that they could attain the increased flow on their cash.It avoids the increase of their debts too.
Thank you for your article. Factoring is a great way for small and mid-size companies to free up the cash they have tied up in accounts receivable. However, it’s a cash flow management practice that still requires a lot of “evangelizing” and education.
Factoring has also become highly specialized. For example, health care and medical companies that wish to factor Medicare claims must work with a factor that knows how to set up this type of factoring or risk losing their ability to submit claims to the government. Firms engaged in the construction industry, wholesale produce, staffing, etc., all have to select factors that can provide a factoring plan that can accommodate their specific factoring requirements.
This is one of the reasons why many firms that are testing the waters with factoring for the first time or that simply want to save time and aggravation, are relying on advisors to help them select the factoring companies with the experience and capability to provide the exact factoring solutions they need.
Factoring is a great tool for businesses that issue invoices, especially those struggling with inconsistent cashflow. Good article :)