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What Is Factoring?

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Last editedMar 20222 min read

Chasing up oninvoices can be time consuming and costly for businesses. Some business owners choose to outsource this process by selling them to a third party for collection – a process known as factoring. So, what is factoring in financial management, and is it right for you? Here’s what you need to know.

What is factoring in a business?

Factoring, also called receivables factoring, is a way for businesses to sell invoices to a third party. This third party is called a factor or factoring company, usually part of a bank or independent finance provider. Invoices are often sold at a discount, giving incentive to the factor to collect payment in order to make a profit. While the original business does not recover its full payment due to selling at discount, it benefits from an immediate boost to its cash flow from the sale.

What is factoring in commerce: how does it work?

In this process, a business sells itsaccounts receivables to a third-party factor. The factor assumes ownership of the debt and then is free to pursue the debt settlement. What is factoring in a business used for? It’s typically designed toaccelerate cash flow. Here’s how it works:

  1. The business signs an agreement with the factor to transfer ownership of the receivables.

  2. The factor manages the receivables for a fixed period, typically 24 months. In return, the factor will pay a percentage of the outstanding invoices upfront whenever the business sends an invoice to a customer. The factor will usually pay about 75% of the invoice upfront.

  3. When the customer makes a payment, it’s paid directly to the factor rather than the business. The factor collects the debt and pays the remaining invoice balance to the business.

  4. As compensation, the factor takes a cut of the invoice in a fixed fee or percentage of its total cost.

The arrangement will remain in place until the end of the factoring contract, at which point the business can decide to retain control over its own accounts receivable or not.

What is factoring in finance: advantages

Now that we’ve answered the question of what is factoring in commerce and how does it work, it’s time to turn to the advantages.

Sometimes, a business becomes bogged down in debt and needs an influx of cash to pay its own bills. In exchange for paying a fee, the business benefits from unlocking funds that might currently be tied up in outstanding invoices. This increases its working capital, for a more advantageous proportion between revenue and liabilities. Using a factor also saves the business a great deal of admin time, because the factoring company agrees to take on all pursuit of accounts receivables for a fixed period.

From the factor’s end, this process provides the benefit of purchasing uncollected receivables at a discounted price. The factoring company takes on the work of chasing invoices, but it earns profit in return.

What is factoring in finance: disadvantages

There are clear benefits to the business and factor, but this type of arrangement won’t be right for everyone. Although factoring can be a great way for a business to collect immediate debt, most companies will lock customers into a long-term contract. This means that once the first payments are collected, you still must work with the factoring company to collect future invoices.

It’s also vital to look carefully at the fee structure before entering any contract. A factoring company’s fees might look favourable at first glance, but they may add on extra disbursements and monthly administrative fees.

What is factoring in financial management: the bottom line

There are certainly pros and cons to factoring. This type of practice is usually unsuitable for small businesses or independent contractors that might only deal with one or two clients. In those cases, you’re best dealing with your client directly to maintain a friendly working relationship. However, if your business issues hundreds or even thousands of invoices every month, outsourcing the work to a factor might pay off.

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