What is Business Factoring?
Factoring is one of our oldest forms of financing and is extremely commonplace in other parts of the world.
It sounds like one of those deceptively simple business terms that in actual fact can leave our head spinning as we try to figure them out.
But really, factoring is child’s play when compared to other business or financial concepts.
You can even see it as quick and easy cash, relatively speaking.
Don’t believe us? Read on!
What is Business Factoring?
Business factoring is a financing method which allows a company to sell its unpaid invoices or accounts receivable to a third-party at a discount, commonly referred to as a “Factor”. You can also factor purchase orders, but we are not discussing that in this article.
The Factor then takes over the right to collect the outstanding amount from their client’s customers. Typically a Factor pays a portion, e.g., 60 to 85 percent of an invoice’s face value upfront, before forwarding the remainder less discount upon full payment from the customer. Yes, your company gets immediate access to cash without having to wait the 30 to 100+ days you normally collect your receivables.
Discount rates vary by industry but 2 to 6 percent is common.
Many businesses turn to factoring to ease cash flow especially for long receivable cycles, or to raise capital fast for expansion. It is most often used as a stepping stone to get your company in the position to take advantage of growth opportunities, until you can become more “bankable” and qualify for more traditional means of financing.
Some may mistake it as a loan facility but you are actually selling off part of your assets, in this case the accounts receivable.
Business Factoring vs. Line of Credit
Which brings us to whether factoring or a line of credit is better for a business in need of additional financing. Besides factoring being an asset-based transaction vs. the revolving loan of a credit line, here are other factors (pun intended) you should consider as well.
A Factor’s discount rate is generally less expensive than the interest rate of a business credit line. Especially if your company is hardly the darling of credit providers or has a relatively high profit margin.
The creditworthiness of your customers and NOT your business is one of the first things a Factor looks at. How long does this customer usually take to pay? Partial or full payments? The rosier the credit checks on your customers, the sweeter the discount rate is for you.
The due date plus value of an invoice also come into play. While some Factors offer discounts only for due dates of up to 60 days, others charge a higher rate for anything beyond.
On the other hand, depending on the loan amount, repayment term, collateral pledge and your firm’s credit score, a business line of credit can set you back by quite a lot. Traditional banks will offer an APR of Libor/SOFR + a few basis points, while non-traditional banks can get expensive. These rates can typically range up to 60%, but some can be even higher.
Many factoring lines are low-maintenance and extend quite naturally from your normal operations. All you need is common business sense to keep a factoring line going – work with reliable customers that pay on time and keep your business as a going concern.
Maintaining a line of credit can be more onerous. That’s because most come with covenants such as:
- Detailed financial records
- Healthy financial ratios
- A certain level of corporate net worth or market value
Needless to say, these tend to favor larger, rather than smaller, companies.
Again, a line increase for factoring is pretty straightforward. Because it often means you are sending out more invoices to an expanding customer base for a growing business. It’s a clear win-win because a Factor stands to profit directly from yours, as long as your new customers are good, paying ones.
But not as much when it comes to increasing a credit line. Even when your tills are ringing louder and faster, a lender would want to look again at your cash flow, assets or even the entire financials. Some could demand a larger collateral, when the equivalent for factoring is simply the accounts receivable themselves.
Should You Consider Business Factoring for Spare Cash?
Factoring is a relatively fuss-free way of raising cash, but it does eat into your profit margins. A margin of 15% or more may allow more wriggle room to consider factoring for your business.
Liquidity-wise, it can also work both ways; to end a factoring line you would need to return any amount the Factor has advanced you if your customer has not paid them yet.
Finally, do not forget the human touch too. How would it affect your future relationships with customers if you effectively outsource invoice collection to an unsentimental “debt collector”?
To Factor or Not?
So, what’s your call? If you need help with your financials or projections before deciding, or to choose a Factor, reach out to us at U-nique Accounting.
15 years of experience in providing accounting and CFO services have given us a truly unique perspective your business deserves.
Book a complimentary 15-minute call with us today to hear and see it for yourself.
Till the next time!