Struggling with cash flow due to slow-paying clients is a common issue that can stifle the growth of your business. One effective solution? Factoring. It provides immediate access to funds by converting your outstanding invoices into cash.
But is this the only reason? Why do companies use factoring? This article explains the reasons why factoring is an attractive option for businesses, how it works and whether it’s the right fit for your business.
What is factoring and how does it work?
Factoring is a process where a business sells its accounts receivable (invoices) to a third party, known as a factor or a factoring company, at a discount. This process allows companies to unlock immediate cash flow rather than waiting for customers to pay their invoices, which can take 30-90 days.
Here’s how it works:
- Invoice creation: The business provides goods or services to a client and issues an invoice with a payment term, typically ranging from 30 to 90 days.
- Selling the invoice: Instead of waiting for the client to pay, the business sells the invoice to a factoring company. It advances 70% to 85% of the invoice value immediately.
- Client payment: The client/customer then pays the invoice directly to the factoring company when it becomes due.
- Final settlement: Once the factoring company receives the full payment, it releases the remaining amount to the business and charges a factoring fee for the service.
Different types of factoring involve spot factoring, recourse factoring & non-recourse factoring and reverse factoring.
Compare Invoice Financing Quotes Today
What is an example of factoring?
A small manufacturing company, ABC Manufacturing, produces custom machinery for various clients. After completing an order, ABC issues an invoice to a client for £100,000 with a 60-day payment term.
Now it chooses invoice factoring as a means to get immediate cash. They sell the £100,000 invoice to a factoring company, which advances 80% of the invoice value upfront. This amounts to £80,000.
When the client pays the factoring company after 60 days, the factor deducts a fee of 2% (£2000) and then transfers the remaining £18,000 to ABC Manufacturing.
According to a report by Invoice Funding, the number of UK businesses using some form of invoice factoring stands at around 45,000.
Why do companies use factoring?
Why would a business use factoring? Well, companies use factoring for several compelling reasons.
1. An effort to improve cash flow
One of the primary factoring benefits is the ability to unlock cash tied up in accounts receivable. Instead of waiting for months for payments, businesses can access immediate funds, which can be used for operational expenses and investments.
2. Chance of staying away from loan
Unlike loans, factoring doesn’t add debt to a company’s balance sheet. It’s a sale of an asset (the invoice), not a borrowing activity. This improves the company’s financial ratios, making it more attractive to investors and lenders.
Furthermore, getting a loan is a time- and effort-taking process. Many businesses might not have the collateral for the loan. Others might not have a good credit score. Factoring serves as a bridge for such businesses that may not qualify for loans.
| Aspect | Loan | Factoring |
|---|---|---|
|
Debt on the balance sheet |
Adds debt to the balance sheet, which affects creditworthiness.
|
No debt is added; factoring is a sale of an asset.
|
|
Approval process |
Lengthy approval process which requires a strong credit history.
|
Faster approval, mainly based on the creditworthiness of the business’s clients.
|
|
Repayment obligation |
Fixed repayment schedule that must be followed regardless of cash flow fluctuations.
|
No repayment obligation; funds are received upfront and the invoice is settled when the client pays.
|
|
Collateral requirement |
Often requires significant collateral such as property.
|
No traditional collateral required.
|
3. Opportunity for scalability
Factoring is inherently flexible and can scale with a company’s sales. As the business grows and generates more invoices, the amount of available funding through factoring grows as well. This scalability makes it ideal for rapidly growing companies that need to keep pace with their cash flow needs.
4. Mitigates payment risk
Good factoring companies often conduct credit checks on the business’s clients/customers which reduces the risk of non-payment. This additional layer of security can be particularly valuable for businesses dealing with clients who have longer payment terms.
5. Frees up time to focus on core business activities
By outsourcing accounts receivable management to a factoring company, businesses can get some breathing space from chasing the payments.
This allows them to focus on core business activities like improving sales, optimising production processes and enhancing customer support.
6. Provides seasonal business growth
For businesses with seasonal demand fluctuations (like home decor), invoice factoring can provide the necessary cash flow during peak seasons. It ensures that the company has the funds to stock up on inventory, hire additional staff or launch marketing campaigns when they’re most needed.
Which companies can benefit from factoring?
Factoring can be advantageous for a wide range of companies, especially those facing cash flow challenges.
- Startups and growing businesses: Startups and rapidly growing companies often struggle with cash flow due to delayed payments from customers. Factoring provides immediate capital to support their growth without the need for a lengthy credit history.
- Seasonal businesses: Companies in industries with seasonal demand, such as e-commerce, home decor and blanket retailers, can benefit from factoring during peak seasons.
- Industries with high accounts receivable: Companies in industries like manufacturing, wholesale and construction often have significant amounts tied up in accounts receivable. The process of factoring allows them to convert their receivables into immediate cash.
- Businesses in a turnaround phase: Companies undergoing reconstruction or experiencing financial difficulties can use factoring to stabilise their cash flow. This instant injection of funds can assist them in managing expenses, settling debts and focussing on recovery.
Who wouldn’t benefit from factoring?
Factoring isn’t a one-size-fits-all solution. For some businesses, it might not be the best option.
- Businesses with strong cash flow: Companies that already have a steady and reliable cash flow may not need factoring or even invoice financing. If payments from customers are consistent and timely, the cost of factoring might outweigh its benefits.
- Low-margin businesses: For businesses operating with slim profit margins, the fees associated with factoring can eat into already tight margins, making them less profitable.
- Businesses concerned about client relationship: Factoring involves third-party interaction with your customers, which can sometimes strain relationships. They might not be comfortable getting a product/service from one party and paying the money to another. Business owners who value direct relationships with their clients may be hesitant to involve a factor in their transactions.
- Highly regulated industries: Businesses in highly regulated industries, such as healthcare or finance, may face compliance challenges when factoring invoices. This becomes even more problematic if sensitive customer information is involved.
Want to improve the cash flow of your business with invoice factoring? ComparedBusiness can help
ComparedBusiness provides you with secure invoice factoring services from top providers in the UK. Just submit your requirements in less than 2 minutes and we will match you with them. You will be able to get the advance amount within days.
Factoring is used to improve cash flow by converting unpaid invoices into immediate funds. Businesses sell their accounts receivable to a factoring company at a discount, allowing them to meet urgent expenses, reinvest in operations or smooth out seasonal fluctuations without waiting for customers to pay.
Factoring has various benefits. It provides quick access to cash, improves cash flow, reduces the risk of bad debt and eliminates the need for collateral to get funding from lenders. Additionally, factoring companies often handle collections, which reduces administrative burden.
Factoring involves 3 main parties: the business (which sells its invoices), the factoring company (which buys the invoices and provides cash upfront) and the customers (who owe payment on the invoices). The factoring company collects payments directly from the customers on behalf of the business.
