Factoring 101: What is Factoring?

Posted at October 22, 2020 » By : » Categories : Business Funding »
what is factoring

Does your company need cash now? It’s not unusual for successful small-to-midsize businesses to struggle with cash flow. That’s especially true for companies relying on large invoices with long payment terms. Knowing what is factoring and how it works could help your cash flow.

If you’re in that predicament, invoice factoring might be the answer to your problems. It can even help you get rid of that stack of unpaid invoices sitting on the corner of your desk. When you’re ready to hear how to turn your troubles into positive cash flow this month, read on.

What is Factoring?

Invoice factoring is often referred to as “accounts receivable financing”, or just “factoring”. It’s a process by which businesses sell unpaid invoices, or accounts receivable, to a third-party known as a factoring company, or just factor.

The factor purchases the invoices for a percentage of their total value. The factor also takes responsibility for collecting the outstanding balances on the unpaid invoices.

The process has become an increasingly popular alternative for businesses with imperfect credit or who are experiencing growth. Sometimes these types of businesses struggle to find funding through traditional financing from banks.

How Factoring Works

If you’re wondering how factoring works, it starts and ends with the invoices. The quality of your invoices and the credit of your clients are two things that most lenders consider to be important.

The first thing you need to do is to search for a good factoring company. Here at Your FundingTree, we help business owners find the best funding solution for their company. Once you have found a factoring company, it’s time to apply for funding.

A factoring company will ask for a number of items during the underwriting process. During which, you will submit the invoices you want funding on to the factoring company. They review the details of the invoices and the credit of the clients you want to fund with them.

The factoring company determines the risk of funding your invoices and will give you their rates and terms in a factoring agreement. If they send you a factoring agreement, and after you read it, you decide whether or not you want to fund with them.

You avoid the hoops you have to jump through during a traditional bank loan, like providing your profit and loss statements. If you don’t agree with the rates and terms of their factoring agreement, you can shop around and look for other factoring companies.

If you reach an agreement with the factoring company, it will begin to fund your invoices. In short, the factoring company will purchase your invoices, send you money, and collect the payments which are due from your clients.

In What Circumstances Would You Use Factoring?

One of the problems that your business might run into is maintaining working capital. Your invoice payment terms could be 60 or even 120 days long. Unless you have huge cash reserves, running your business for an entire quarter without receiving payments destroys your cash flow.

You fill this gap by maxing out your company credit cards and applying for online business loans. Constantly running into cash flow problems can result in reoccurring bank overdraft fees and owning a company with bad credit.

Disadvantages

You’re handing the ownership of your accounts receivable to a third party. When a third-party takes over your invoice collections, it may adversely affect your client relationships. Some of your clients might not want to deal with a third-party and they could end up taking their business elsewhere.

Factoring might reduce your chances of borrowing from other financial institutions because your accounts receivable is already being used as collateral. Invoice factoring is more expensive than low-interest loans from traditional banks or other asset-based lenders.

Advantages

Factoring will help you increase and maintain a positive cash flow. That’s especially true if you’re having to offer lengthy payment terms to multiple clients. Turning your invoice collections over to a third-party may improve your chances of receiving quicker payments from your clients.

Most funding companies are extremely knowledgeable with collections. They are designed to gently prod even the most stubborn clients into paying their invoices. Equity investors cost more than invoice factoring and may put your business in jeopardy.

The amount you can fund with your lender is flexible and depends on the total amount of your invoices. Since you don’t have to track down payments, you can spend that energy elsewhere in your business. You immediately transform potential capital into working capital.

How Much Does Factoring Cost?

Just as with any loan, costs vary. These are some of the considerations that determine the cost of financing your invoices:

  • Credit rating of the clients you want to fund
  • Total dollar amount of the invoices
  • How long it takes for your invoices to get paid
  • What industries do you provide services or products to
  • Status of the economy
  • Your personal and your business’s credit rating

Each of these considerations are evaluated during the underwriting process. They help to determine the rates and terms that are listed within the loan agreement. Thoroughly reading the loan agreement prior to signing it is a must.

How Invoices are Purchased

A factoring company who purchases your invoices will involve sending you money twice. The initial advance they send to you is 90% of the invoiced amount. For this example, realize every loan agreement is different, and this is only an estimate.

When your clients pay their factored invoices in full, the factor pays you the final 10% of the invoiced amount. They subtract their factoring fee from the 10% being sent to you. Here is a simple breaks down of the process:

  • Submit your invoices to funding company
  • Funding company advances you approximately 90% of the invoiced amount
  • Client pays funding company 30-60-90 or even 120 days later
  • Funding company advances you approximately 10% minus their factoring fee

Though percentages vary, the two-stage advance process typically stays the same regardless of which factoring company you use.

Knowing What is Factoring Means it’s Now Time to Apply!

Now that you better understand invoice factoring, you have some decisions to make. First, determine whether you have the invoices to qualify for a funding relationship with a factoring company. Then decide whether an increase in cash flow is worth the cost of factoring.

If you’re still considering factoring or other types of funding for your business, apply with us and have lenders lining up to compete for your business today!