Factoring is another way to describe accounts receivable financing. It is NOT a loan, and consequently, does not adhere to the stringent credit or collateral requirements of traditional lenders. If you have an immediate need for cash, factoring is an alternative cash management tool for you to explore.
Learn the what, how and why of factoring.
What is Factoring?
Simply put, factoring is an alternative financing method where a business sells its invoices (accounts receivable, AR) to a 3rd party (or factor). For a fee, the factoring company takes on the risk of any bad debt associated with the invoices in order to provide your business with quick cash.
How Does Factoring Work?
You provide a service to a customer. Instead of sending the invoice to the customer, the factoring company will buy your invoice and assume responsibility for collection of the debt. At this point, you receive a cash advance from the factor. The factoring company can issue up to 95% of the invoice to you depending on the industry and your customer’s credit history. Once the invoice is paid in full to the factor, they will pay you any reserve balances minus a fee for assuming the collection risk.
Why use Factoring?
Any industry that tends to have a long receivable business cycle will find factoring appealing. With standard bill collection, a business must wait 30-60 days for a billed customer to pay. Waiting for AR to come in can stifle a business’s growth. But, a factoring company can issues funds quickly—in some cases within 1 business day. This is extremely beneficial to startups, who may not qualify for a standard business loan because they have not established a credit history but still need cash flow. Since factoring is NOT considered a loan, it will not show up as debt on a balance sheet.
Remember, a factoring company is NOT a non-profit. They are advancing you cash to make money. And as with any kind of financing, there are risks involved. Factors will retain around 4% of the invoice as a fee. In addition, they will charge interest on the cash advance that is typically a couple of points higher than prime. Another point to consider is that a factoring company will require you to enter into a contract that may be longer than you want or need. However, if cash flow is crucial and/or you cannot qualify for a business loan, factoring may be one of your only options to keep things running smoothly.
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