Factoring is just one of the many methods and types of business finance. While virtually everyone is familiar with the concept of “getting a business loan”, that is too simplistic. There are, in fact, many types of business loans and, in some cases, the method of business finance is not actually a loan. That is the case with commercial factoring.
In simple terms, factoring or accounts receivable factoring is the sale of the accounts receivable of a business (invoices) at a slight discount to a finance company known as the factor. Factoring is commonly employed by businesses that sell B2B and grant extended terms of payment to their customers for goods or services provided, allowing those customers to delay payment upon invoices for 30, 45, 60 days or sometimes even longer. Factoring is probably the oldest form of commercial finance known to man and is employed as a popular business finance strategy in almost every corner of the globe.
It is important to keep in mind as you develop your knowledge of this powerful financial tool, factoring differs dramatically from most other forms of commercial finance in that true factoring is never in the form of a loan. Factoring is actually a purchase and sale transaction. Factors actually buy the accounts receivable of the business they are financing, a trait that sometimes gives factors certain funding advantages over more common commercial lenders.
Growing a Business Through Factoring
For entrepreneurs in the early stages of developing their businesses, factoring represents one of the most powerful financial tools available. Factoring…
- is available to businesses in the earliest “start up” stages of operation
- requires little or no credit history for either the business or it’s owner(s)
- provides a financing facility that automatically increases in size and availability as the client’s business grows
- provides substantial back office operational support in addition to providing working capital
- allows other business assets to be financed separately from accounts receivable.
Invoices and Terms of Payment
As you will learn as you continue to study this course, most factoring arrangements are sought out simply to provide a readily accessible method of financing a company’s terms of payment policy and to remedy the cash-flow problems a business often experiences by granting such attractive terms of payment to its customers. At some point in time, as B2B companies grow, they are almost required to initiate a terms of payment policy. Terms of payment are granted by sellers as an accommodation for a singular purpose…that is to attract more purchases from large (and sometimes not so large) creditworthy customers.
Many large, creditworthy customers, on the other hand, demand terms of payment for a singular purpose…..that is to benefit from the payment delay provided under the terms of payment policy and to allow time to sell products or provide their own services and to generate enough additional cash to subsequently pay their supplier’s invoice within the normal payment terms.
Why Customers Demand Extended Terms of Payment
For large corporations, the benefits of being granted extended terms of payment from vendors are very significant. When one business grants terms of payment to another, it is in effect, creating a short-term non-interest bearing business loan to that company. Large corporations can dramatically change their cash-on-hand balances by demanding longer terms of payment when they order or by simply increasing the length of time that passes before they actually pay their bills (known as aging your invoices).
Take for example, a large national retailer that has current accounts payable of $50,000,000 and routinely pays its invoices in 30 days. By simply increasing its terms of payment from 30 to 45 days, it will wait an additional 15 days prior to paying vendor invoices and will, in effect, be able to create an interest free loan to itself of $25,000,000 at the expense of its suppliers.
Because of the attractiveness to large companies of delayed invoice payments, it is not unusual to see contracts and large purchase orders granted to those vendors and suppliers that offer the most attractive payment terms, even if the prices for goods or services are slightly higher than from competitors.
For most businesses (or at least those that have some capability of operating at a profit), providing extended terms of payment to customers is one of the most common reasons for problems of cash flow and for periodic working capital shortages. And as you will soon learn, the most popular method of commercial finance world-wide that directly addresses the problems caused by extended terms of payment is commercial accounts receivable factoring.
The Basics of a Typical Factoring Transaction
Though we will deal with factoring transactions in more detail later in this course, it is important to understand the basics as you begin to explore this powerful yet easily accessed form of commercial finance. It is well understood in financing circles that one of the real strengths of commercial factoring as a method of business finance is its simplicity.
In a typical factoring transaction, a business owner (known as the client) will enter into a relationship with a commercial financing source (the factor) to which it periodically sells its invoices payable by its customers. In most modern factoring transactions, the invoices are initially purchased by the factor with an initial advance of cash (usually 75-85% of the invoice face value). By periodically purchasing a business’s invoices, the factor provides immediate working capital for normal operations including timely payment of its bills due to suppliers and its periodic payroll obligations.
With a factoring arrangement in place, the customers of the seller get to enjoy their 30, 45 or even 60 day credit terms while the factor, not the seller, patiently waits for the agreed payment. If necessary, the factor will make collection calls on behalf of the seller, provide weekly accounting of all collections and fees charged, and provide monthly statements of account to the seller’s customers. In effect the factor becomes a “back office” partner of the client.
When payments upon purchased invoices are ultimately received from the customers, the factor deducts its fee for services (the factoring fee), repays itself for the earlier advance, and then rebates the balance to the seller (client). In most modern factoring arrangements, clients will sell their invoices to the factor on at least a weekly basis but sometimes as often as daily.
Find Out More
You can find out much more about factoring and its power to address common problems of cash flow experienced by small business owners by joining the IACFB’s LinkedIn Group and also by visiting IACFB’s magazine for industry brokers, Commercial Finance Consultants.