Factoring is a financial transaction where a company sells its accounts receivable (invoices) to a third party, known as a factor, at a discounted price. The factor then assumes the responsibility of collecting the outstanding payments from the customers. Factoring provides businesses with immediate access to cash flow by converting their accounts receivable into cash. Instead of waiting for customers to pay their invoices, the company can sell those invoices to the factor and receive a percentage of the total value upfront. The factor then takes over the task of collecting payments from the customers, often assuming the credit risk associated with those invoices. The discount or fee applied by the factor is typically a percentage of the total invoice value, and it may vary based on factors such as the creditworthiness of the customers, the volume of invoices being factored, and the terms of the agreement between the company and the factor.
Factoring can be beneficial for businesses that experience cash flow constraints or need immediate funds for various purposes, such as meeting operating expenses, investing in growth opportunities, or managing working capital. It provides a way to convert outstanding invoices into immediate cash, without having to wait for customers to pay.
The Factoring Process
The factoring process begins with a financial institution or private finance company purchasing a brand’s accounts receivable (the money due to a brand as a result of its providing of goods and/or services). The factor advances some portion of the value of the receivables to the brand up front, using the receivables as collateral. The factor then collects the payment directly from the brand’s customer (commonly a retailer) usually 30, 60 or 90 days thereafter. Once the receivables are collected, the factor pays the brand the amount it initially held back, minus the fees it charges for its services. As for the fee structures utilized by factors, most companies tend to keep fee structure information confidential, holding that the business is “too competitive to disclose this information.” (BFM).
However, “the overall cost generally includes a rate charged on the value of the advance. According to several factors, the percentage rate on invoices can range from 2 to 6 percent every 30 days; invoices that the factor feels are riskier generally carry a higher fee.” (BFM). If the retailer cannot pay, the factor usually must pay the full invoiced amount to the brand, although the factoring transaction can be structured with or without recourse. Therefore, factors are more concerned about the retailer’s creditworthiness than the brand’s.
Types of Factoring Arrangements
Brands can typically choose between two types of factoring arrangements. In a non-recourse arrangement, “the factor assumes all risk of nonpayment. If the customer doesn’t pay, the factor has no legal claim against its customer.” With a recourse factoring arrangement, “once a receivable has been outstanding for a certain period of time, such as 90 days, and is deemed uncollectible, the factor can reduce the reserve payment by the amount of the uncollectible invoice.” (BFM).
Factoring vs. Financing
Factoring differs from traditional financing. “It is not to be confused with financing, you may need to produce the goods. Factoring is not production related lending. You’d need to come up with the money to buy fabrics and pay your contractors ahead of time.” (FI). Additionally, “factoring varies significantly from traditional bank loans; each weighs different factors of a business’s financial health. Factors weigh a company’s balance sheet in strikingly different ways. One dramatic example is inventory. Traditional banking perceives inventory as an asset while I consider inventory to be a liability -as does any lean manufacturing proponent.” (FI).