What is factoring?
Factoring – also known as ‘debt factoring’ or ‘invoice factoring’ – involves selling your invoices to a third party. In return, they will process the invoices and allow you to draw funds against the money owed to your business.
Businesses that supply this service are called factors or debt factoring companies. Essentially, these companies provide finance, debt collection, and ledger management services.
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Types of factoring
Spot factoring
Spot factoring (also called single invoice factoring) enables a business to sell individual invoices selectively. This type of factoring gives businesses the flexibility to choose which invoices to factor based on their cash flow needs.
Reverse factoring
Reverse factoring, also known as supply chain financing, is a three-way agreement between a supplier, a buyer, and the factoring company. The factoring company pays the supplier on behalf of the buyer, offering quick payments at a discounted rate.
Account receivables factoring
Accounts receivable factoring is used interchangeably with invoice factoring. It involves the business selling its unpaid invoices to a third party (factoring company) at a discounted rate to receive early payments. Upon receiving the invoices, the factoring company releases the bulk of payments (up to 90% of the collective invoice value). The rest is paid (after fee deduction) when the payment is collected in full from the end customers.
Debt factoring
Debt factoring, also known as receivables factoring or invoice factoring, involves a business selling its accounts receivable (unpaid invoices) to a third party. The factoring company buys these invoices at a discounted rate, providing immediate cash to the business.
How does factoring work?
Factoring works in the 3 easy steps:
Sell to your customers: Sell your goods and services to customers and generate invoices.
Sell your invoices: Sell your invoices (account receivables) to a factoring company that pays you up to 90% of the invoice value up-front. The remaining amount is released (after fee deduction) when the factoring company receives full invoice payment from customers.
Use money to fuel growth: Use the money to finance your business growth. Fix cash flow issues, buy new equipment, expand operations, or invest in human capital.
Advantages of factoring
Factoring offers a range of benefits for businesses, including:
Improves cash flow
It provides quick access to cash from invoices, helping businesses manage everyday expenses, payroll, and investment opportunities without accruing debt.
Fast capital access
Factoring companies often release funds within 24 hours and are available for capital investment and funding of your next orders. It is much quicker than traditional business loans, like bank or SBA loans.
A good credit rating is not compulsory
It is easier to qualify for than other loans, as factoring companies focus on the creditworthiness of the business’s customers, not the business itself. It’s suitable for startups and businesses with poor credit.
Better quality customers
A factoring company with a strong credit team can help you avoid working with customers who have poor payment histories. This will ultimately help your business trade with better-quality customers
Disadvantages of invoice discounting
Reduces profit
Businesses receive less than the total invoice value, reducing overall profit.
Can be expensive
Factoring fees (1% to 5% of the invoice amount) can make it more expensive than other loan options. Most of the factors also require a ‘discount charge’ which is calculated against the balance of funds drawn and usually applied every month.
Potential debt responsibility
In recourse factoring, businesses might have to repay the factoring company if customers don’t pay, bearing the loss themselves. Non-recourse factoring transfers this risk to the factoring company but usually comes with higher fees and stricter qualifications.
Ending factoring agreement
To stop using a factoring service, a business must pay back any money the factor advanced for invoices that haven’t been paid by clients yet. For example, if a business got an advance of £20,000 on an invoice and the customer hasn’t paid, the business needs to repay that £20,000 to end the factoring agreement.
May negatively impact customer relationships
How the factoring company deals with your customers will affect your relationship with your customers. In some cases, customers might take the impression that your business is financially unstable.
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