Factoring is a type of asset-based finance used by companies to receive early payment upon their invoices (accounts receivable). It deals directly with the problems of cash flow that arise when one business grants liberal extended terms of payment to another upon invoices for goods delivered or services rendered. While the granting of extended payment terms enhances a company’s ability to attract new creditworthy customers and to receive larger orders, it can also be the cause of severe cash shortages while the grantor waits for such payments to finally come in. Accounts receivable factoring directly addresses such problems of cash flow caused by the granting of extended payment terms.
A Purchase and Sale Transaction
Unlike traditional business lending, factoring operates as a purchase and sale transaction rather than a loan. Factors actually purchase the invoices (accounts receivable) of a business and in doing so, accrue the rights to collection upon them. True factoring is never a loan and because of this unique characteristic, factoring finance is available to almost any business that operates on a B2B basis and sells or provides services to quality customers.
Unlike banks that look to be repaid on loans from the cash flow of the borrower, factors are repaid from payment upon invoices from the customers of the business. It is therefore the customer’s credit that is of importance to the factor, a fact which allows even early-stage, startup business with little or no credit to still be eligible for factoring.
Eligibility for Factoring
Almost any business can utilize the powerful cash flow problem solving capabilities of factoring so long as…
- their invoices have payment terms that are “unconditional”
- the goods or services have actually been delivered or rendered
- the invoices are verifiable
- the account debtors (customers) are creditworthy
- there are no previous lenders in place with senior collateral rights to the purchased invoices
- there are no active liens (such as tax liens) or judgments in place affecting the factor’s ability to receive invoice payments
Worldwide, factoring is one of the most common forms of commercial finance used to for B2B (business-to-business) commerce with trillions of dollars of transaction being accomplished annually. The United States alone accounts for well over $100 billion in factoring volume annually. It is far surpassed by Europe with individual countries such as Italy, Germany, and the United Kingdom all eclipsing our domestic factoring volume. In short, although not a household name, factoring is BIG business.
One of the reasons for the worldwide popularity of factoring is it’s transactional simplicity. In fact, almost no other form of business finance is easier to establish and access. For small business entrepreneurs, a factoring arrangement can typically be established in just 3 to 4 days and once set up, funding can occur daily, weekly bi-weekly, monthly or virtually anytime.
To receive financing, factoring clients…
- batch and submit the invoices they wish to sell to their factor
- once received, the factor will process and verify the invoices to be purchased
- an advance (typically 80% of face value) is made and wired directly into the client’s business bank account
- Once invoices are paid by the client’s customers, the payments are processed and the client receives the balance not advanced (20%) as a distribution less the factor’s fee for services
Setting Up a Factoring Arrangement
For small business owners in need of cash flow solutions due to slow paying customers, setting up a factoring arrangement could not be easier. There are, however, many specialized niche areas in factoring such as construction, agriculture, government, trucking, staffing, medical, etc. and it can be difficult to find just the right factor.
Typically, a business owner will be referred to a factor and that referral will come from a knowledgeable source such as…
- A lending officer and the business owner’s bank
- An accounting professional / CPA
- A Commercial Finance Consultant (Factoring Broker)
- SCORE adviser or member of support staff at an SBDC