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Updated: March 27th, 2020
Many companies that are just starting out or are experiencing cash flow difficulties turn to factoring as a short-term solution. Instead of waiting the 30 to 90 days it may take for their customers to pay outstanding invoices, factoring allows the company to sell the invoice at a discount to a third party and receive an advance on the invoice within one to two days for immediate use in the business.
Factoring is not a new concept – in the early 1400s, overseas traders used factoring to finance international trade. International businessmen used their factored invoices to fund the voyages to pick up the goods they had sold. There is even some evidence that factoring was used in ancient Mesopotamian civilizations.
Factoring sells an invoice or invoices to a third party. The factoring company takes responsibility for collecting on the invoice, using the receivable as collateral. In exchange, they charge a percentage of the total amount owed on the invoice.
Invoice factors have 3 parts: the advance, the discount fee and the reserve. The advance is the lump sum paid to the business within one to two days for immediate use. Advances vary depending on the amount of the invoice and the industry, but are usually 70 to 90 percent of the invoice total. and The discount fee is the amount the lender charges for taking on the risk of the debt. Discount fees are typically 1.5 to 6 percent of the total due. The reserve is the remaining percentage of the invoice, minus the discount fee, that is paid out to the company once the invoice has been paid.
Factoring offers the advantage of giving companies faster access to funds than the normal 30 to 90 days a customer has to pay their invoice. Although the terms and turnaround can vary according to the industry, typically a business can sell their invoices to a factoring lender and receive a large percentage of the invoice total within 48 hours.
Invoice factoring is also beneficial to companies that are either financially challenged or still in the process of building momentum that don’t qualify for traditional financing. New companies with lower revenues often move from factoring to accounts receivable financing to term loans as their business grows and their creditworthiness increases. However, there are also many industries that use factoring routinely due to the nature of their business, such as trucking, transportation, distribution, textiles and manufacturing.
Invoice factoring and accounts receivable financing are often confused, as they both consist of receiving funding based on outstanding invoices. Factoring, however, consists of actually selling the debt to a third party at a discount. Factoring is not considered a debt, and is not reflected as a debt on a company’s balance sheet, which can be an advantage at a future date when the company applies for a traditional loan. In contrast, account receivables financing uses outstanding balances on receivables as collateral for the company to quality for a short-term loan. Factoring is more expensive since the receivable is the only payment source and collateral, unlike in accounts receivable financing, where the lender has both the receivable and additional recourse as collateral against the borrower.
Depending on whether the business has chosen recourse or non-recourse factoring, they may be required to pay back the advanced amount if their customer doesn’t pay. With non-recourse factoring, the business will not have to pay back the advanced amount if their client doesn’t pay, but the fees will be higher due to the increased risk.
In many cases, the discount percentage can increase depending on how long the invoice is due. If the customer is late on their payment, it may decrease the total amount the business receives.
Factoring purchases an invoice outright; in return, the lender assumes the risk of the debt and takes over the responsibilities of collecting on the invoice. Before assuming the risk, the factoring company will review the business customers’ creditworthiness and sales volume. If the customers have bad credit, the factoring company could refuse to buy the receivables, denying the business access to much-needed funds.
Additionally, the business’ customers will be aware that the business has turned over their debt to a third party once they start sending the customer financial statements. This could be detrimental to a business and its reputation, especially if the factoring company doesn’t give its customers the same customer service experience.
Although for certain industries factoring is the most logical choice for funding their operations, most companies use factoring for immediate funding needs when they don’t have the collateral or financial history needed for longer-term solutions. In those cases, factoring can be a helpful tool to for short-term cash flow gaps, allowing the company to build momentum until it can qualify for cheaper, long-term financing options.
Samantha Novick is a senior editor at Funding Circle, specializing in small business financing. She has a bachelor's degree from the Gallatin School of Individualized Study at New York University. Prior to Funding Circle, Samantha was a community manager at Marcus by Goldman Sachs. Her work has been featured in a number of top small business resource sites and publications.