Finance 101: factoring

If you’re looking to raise cash instantly, without getting into more debt, you might want to consider factoring – primarily suited for business-to-business companies.
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The lowdown

One of the oldest tricks in the financial services book, factoring is a short-term solution where a business raises capital by selling its accounts receivables (outstanding invoices) at a discount to another company, known as the factor, which then takes on the risk of default. 

The key details

• There’s a factor fee. Factors charge a fee in exchange for providing cash and taking on the risk. This is usually a percentage of the invoice amount and the final rate can depend on various aspects including the number of invoices, the amount of risk, etc.

• There are two main types. With ‘recourse factoring’, the responsibility – and therefore the risk – for any unpaid invoices lies with the seller (AKA you). Whereas with ‘non-recourse factoring’, even in the case of bad debt, the risk lies with the factor and doesn’t affect your business. 

It’s good because…

• It helps improve immediate cash flow, which you can use to grow your business.

• Having cash in hand gives you an advantage by allowing you to snap up early discounts and deals with suppliers. 

• The factor usually looks after the credit check, collection of debt and the resulting admin, which frees up time so you can focus on the business. 

But not so good because...

• You get a smaller slice of the pie – paying a percentage fee to the factor means your profit margin is reduced. 

• How the factor goes about debt collection can affect customer relations. If it’s negative, this could lead to a loss of goodwill. 

• Risky debtors aren’t a factor’s favorite – often, managing them will still be left to you. 

How it works

1. Generate an invoice. 

Finalize the sale, deliver the products or services and raise an invoice highlighting the terms of payment, including who your customer will need to pay (in this case, the factor). 

2. Sell the invoice.

Once the fee and immediate payment amounts are agreed, share a copy of the invoice with the factor. At this stage, the factor is likely to carry out relevant checks. 

3. Initial advance payment.

After the invoice is received, the factor transfers across the agreed initial amount – usually between 75% and 85%. 

4. Invoice clearance. 

In line with the terms, your customer clears the invoice and pays the total amount directly to the factor. 

5. Final amount transferred.

As soon as the customer pays, the factor will transfer the remaining 15% to 25% to you, minus its fees and charges.

Where next?

If you’re US-based, have been in business for three-plus months and bring in at least $10,000 in monthly revenue, BlueVine might be your match. In the UK, Hitachi Capital (UK) PLC offers a six-month trial to help see if factoring is what your business needs.

A version of this article was published in the Courier Weekly newsletter. For more useful stories, tips, tricks and simply good advice, sign up here.

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