As businesses increasingly rely on alternative financing methods to maintain liquidity, one tool that helps businesses unlock immediate liquidity is factoring. In this article, we will discuss how factoring works, as well as its advantages and drawbacks. Credit professionals should understand the nuances of factoring, as it differs from your typical ABL or revolving credit facility.
What Is Factoring?
Factoring is a financing method where a company sells its accounts receivable (A/R) to a third-party factoring company. In return, the business receives an immediate advance (typically 80% to 90% of the invoice value) with the remainder paid (minus fees) once the customer settles the invoice. Compared to traditional financing, factoring presents fewer barriers to entry, as approval is based on the creditworthiness of the company’s customers rather than its own financial health. This makes factoring especially attractive to startups and small to medium-sized enterprises (SMEs) with limited credit histories or weaker credit profiles.
As explained by Allianz Trade, a factoring company might pay you $80K upfront for an invoice totaling $100K. The factoring company then collects the full amount from your customer. Once the customer pays, the factoring company returns the remaining balance (minus the factoring fee) back to you. The factoring fee is usually a small percentage of the invoice value, typically around 2-5%. This service allows you to quickly access funds tied up in unpaid invoices. In turn, you improve cash flow and cover expenses such as payroll and inventory.
Types of Factoring:
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- Recourse Factoring is the most common type of invoice factoring. In this arrangement, the business remains liable if a customer fails to pay their invoice. The factoring company provides an advance on a percentage of the invoice’s value and charges a fee for the service. However, if the customer defaults, the business must repay the advanced amount to the factoring company. This type of factoring usually comes with lower fees since the risk to the factoring company is minimized. Often chosen by businesses confident in their customers’ ability to pay, recourse factoring offers access to funds while you manage the risk of non-payment.
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- Non-resource Factoring shifts the risk of non-payment to the factoring company. If your customer does not pay the invoice, the factoring company absorbs the loss. This type offers more security, as you are not required to repay the advance in case of default. Non-recourse factoring usually carries higher fees due to the increased risk taken on by the factoring company. This option better suits businesses wanting to reduce the financial risk of non-payment, especially when dealing with new or less reliable customers.
Key Considerations:
Factoring provides rapid liquidity, which is essential for businesses needing quick access to working capital. This enables companies to manage day-to-day expenses, invest in growth opportunities, and take on new projects. Businesses can receive up to 80-90% of the invoice value, often within 24 hours, allowing for financial flexibility. Furthermore, by outsourcing collections to the factoring company, businesses can save time and resources typically spent on managing receivables.
However, factoring fees typically range from 2% to 5% of the invoice value. These costs can accumulate over time, potentially impacting margins. Since the factoring company often handles collections, businesses may also lose some control over customer interactions, which could affect long-term relationships. Lastly, factoring can be more expensive than conventional financing options such as ABLs or lines of credit, especially for businesses with weak credit profiles.
When working with a customer who utilizes factoring, it is essential to understand the structure of their factoring agreement. Additionally, gather detailed information about their current A/R management practices and gain insight into their approach to credit risk management.
