What is factoring?
It's an exciting form of finance for growing companies, but how does it work?
All too often small businesses get carried away with securing that ‘next big order’ without considering if they’ve got the cash to meet it.
That’s understandable and the thrill of landing ‘a biggie’ can tempt us all. But how are you going to buy the parts you need, if you don’t get paid until you deliver or are still waiting to be paid for your last job. Factoring won’t completely solve the problem, but it’ll get pretty close. For businesses high on ambition but low on capital, factoring can work wonders.
Factoring is a flexible form of loan, which advances money to a company as it issues new invoices. This is different to overdrafts or more formal loans, which are usually for a fixed amount.
There are two major advantages of factoring compared to overdrafts or other loans. Firstly, factoring is flexible in that the amount a company can borrow grows with sales. This is often essential to enable companies to fund that growth, since they must usually pay for supplies before they receive payment from customers. The second advantage factoring offers is that no other assets are needed to secure the funding.
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How does it work?
A factoring company will lend a company a certain percentage of each invoice that it issues; it will then collect the invoice when it becomes due and pay the balance back to the issuing company. The factoring company charges a fee, usually a very small percentage of the value of each invoice, and interest on the amount of money borrowed.
A company must notify all its customers of the new arrangement, and hand over the task of collecting debts to the factoring company. Often at the start of a new factoring relationship, the factor will take on existing debtors, which can involve a very substantial payment being made right at the start.
Setting up a factoring deal can be done far more quickly than most other forms of finance.The staff at factoring companies are often more commercial than at some other lending institutions, and will work hard to help find a solution for potential client companies.
What about bad debts?
Even though some factors technically buy the invoices from a company, their contracts are very specific that if an invoice is not paid within a certain time period (usually 90 days) the factor will reclaim any advances it has made against the invoice.
However most factors will offer a “without recourse” service where the debts are insured. This costs quite a bit extra but can be worthwhile. Typically insurance will cover 80% of a debt rather than the whole thing, but when a customer goes bust, getting 80% feels far better than getting nothing at all!
For businesses high on ambition but low on capital, factoring can work wonders.