Business Factoring as Financing Solutions to Increase Cash Flow
Business factoring — also called accounts receivable factoring or invoice factoring
— is one of the oldest business cash-management tools to increase cash to large
and small firms when orders are coming in but the company is unable to secure a
bank loan. It is not a loan, but the sale of business invoices to a third
party, called the factor, at a discount of the account's value.
Business Factoring Benefits and Downsides
The fact is, banks are tightening lending requirements for small-business owners.
Factoring can be a great alternative. Commercial finance companies, banks,
and factoring companies are the traditional buyers of business accounts receivable.
The factoring entity is not an agent, but a principle, and typically bears the risk
of collection without a right to recourse from the borrowing firm if the invoice
is uncollectible. In recourse financing, however, the borrowing business bears the
risk on uncollected receivables.
Factoring may also have downsides. First, the cost of securing factor financing
is typically more expensive than a bank loan. Second, the blanket lien is
a downside to some factoring contracts. The blanket lien gives the factor
a legal interest in all the business’s assets and unsecured collateral. The
liens are generally not released until the invoice is collected. This could
hinder securing other types of financing.
How to Start the Invoice Factoring Process
In the factoring arrangement, the factor pays the business on an invoice’s face
value at a discount. The factor discount is typically 2 to 10%. The
factor pays up to 80% of the account receivable’s face value in cash to the business.
The remaining invoice value, less factor discount, is paid when the customer pays.
Customers can either submit payments directly to the factor (notification basis)
or to the seller (non-notification) basis.
To avoid delays, gather outstanding account receivable related documentation such
as the original invoices and customer payment history. Invoices and associated
paperwork will be checked by the bank or factoring company to determine the customer's
ability to pay the invoice. This information will be the basis for determining
the cash the company will be eligible to receive from the invoice and the discount
rate charged for the services.
Factoring can ease a firm’s cash flow problems when business loans are not readily
available to pursue business ideas during economic downturns. It can offer
flexibility based on the negotiated terms of a factoring contract. It is,
however, a good idea to weigh the benefits and downsides with an experienced professional
to consider the associated risks with any offered factoring contract.