Every business whether it's big or small requires cash to sustain and increase its business and in some cases, businesses need sudden cash to fulfill inventory and other requirements. In this case, a business can use factoring to fulfill instant cash requirements.
Table of Content
What is factoring?
Factoring is a type of financing in which a company sells its invoices to a third party ( factoring company ) to get instant cash. So that the company can manage its working capital more effectively. In this, there is a factor in the factoring company that pays some amount of cash to the company in an exchange for unpaid invoices and collects payment from customers ( unpaid invoices).
What is an example of factoring?
Suppose, a company is selling a good amount of products but has a lot of unpaid invoices. Due to this company is not able to fulfill the inventory requirements. In this case, the company needs instant cash otherwise it may have to suffer from business failure. For this, the company sells its unpaid invoice to the third party which provides them with instant cash which helps Company to manage its cash flow and fulfill inventory and other requirements.
Read also: What is an Invoice and its types, and benefits?
factoring advantages and disadvantages
The advantages of factoring in business:
1. Instant Cash = Factoring provides you with instant cash which you can use to invest in products, equipment, or services.
2. Credit Rating = Factoring improves credit rating by providing the cash. Which businesses use to pay their suppliers and creditors.
3. Overhead Costs = Factoring reduces overhead costs because it eliminates the cost to employ the accounts receivable team in a business.
4. Short-term = Factoring is a short-term solution. So in this, businesses will not have to tie in long-term commitments.
5. Flexible = Factoring can be used at any time during seasonal or occasional orders, or ongoing orders.
6. Risk mitigation = Factoring provides your business with bad debt and takes responsibility to collect payments of unpaid invoices.
7. Loan = Factoring is not a loan. So, you don't have to worry about paying it back.
The disadvantages of factoring are:
There are various disadvantages of factoring in business some of them are:
1. High costs: The factoring company charges discount rates on unpaid invoice amounts and they may charge additional fees.
2. Customer dissatisfaction: when you sell invoices to a factoring company. Then the factoring company has control of invoices, so there are chances of customer dissatisfaction.
3. Credit Risk = if the customer does not pay their bills to the factoring company. In that case, you may be responsible to pay the invoice amount to the factoring company.
4. Limited availability = Not all customers qualify for factoring services, and some factoring companies may not be able to accept some specific type of invoice.
5. Less amount = The amount you get by selling your invoices to a factoring company is less than the original amount of the invoice because of the fee associated with the service. Due to this, you may face challenges to run your business operations.
factoring vs bill discounting
The common thing in factoring and bill discounting is that they both are financing options. The difference between them is that in factoring, the factoring company collects payments from customers, and in bill discounting the business has to collect payment from customers by themselves. Factoring provides businesses with instant cash but bill discounting took time to provide cash in a business.
factoring financing definition
In factoring financing business use their account receivables ( invoices ) in form of collateral to borrow cash from a third party ( Factoring Company ). After that, factor give some amount of cash immediately to the business, and the remainder, less any fees, and charges, when the invoice is paid by the customer.
What are the types of factoring in finance?
There are multiple types of factoring in finance such as:
• Recourse factoring
it is a type of factoring that contains an agreement due to which businesses have the responsibility to pay the debt in their customers will not pay unpaid invoices.
In this factoring company gives its best to collect payments from business customers. But if the factoring company fails to collect a payment, then they can demand compensation from the business. In that, businesses have to buy back unpaid invoices from them and have to repay the funds they get from them. In this, you have to accept losses if customers will pay their unpaid invoices.
• Non Recourse factoring
it is a type of factoring in which the factoring company takes responsibility if the customers will not pay their unpaid invoices then the factoring company has to accept that loss.
But there is some non-recourse factoring agreement that only covers some specific situations. In this type of case, businesses are responsible for the debt if customers will pay the unpaid invoices.
• Domestic factoring
it is a type of factoring in which a business sells its domestic invoices to a factoring company to get instant cash. In domestic factoring, the factoring company deals with domestic customers and pays cash to the business on the bases of unpaid invoices.
• Export factoring
In Export, a factoring company sells its Export invoices in exchange for instant cash. The benefits of export financing are that it reduces credit risk and helps businesses to increase their export sales by providing them with the required funds.
• Disclosed factoring
In Disclosed factoring, the factoring company informs customers that the unpaid invoice has been sold to them by the business. In this customers knows that businesses sold their invoices to a factoring company.
•Undisclosed factoring
This is a type of factoring in which the factoring company will not disclose that the unpaid invoices are sold to them. In this customers do not know whether businesses sold their invoices or not.
• Advance factoring
In Advance factoring, the factoring company gives a certain percentage of cash in advance in exchange for unpaid invoices to the business.
• Maturity factoring
In maturity factoring, the factoring company takes some commission and pays the rest amount of the invoice value to the business. After receiving the cash from the customers.
factoring financing small business
In this, Businesses sell their account receivable to fulfill urgent business requirements by receiving instant cash.
For instance: A business launches a new product but doesn't have enough working capital to spend on advertising and another promotion medium. So, in this case, a small business can sell its unpaid invoices to receive cash and can spend that cash on product promotion or advertising.
Read also: How to deal with cash flow problems in small business
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features of factoring
Some features of factoring include:
1. In factoring businesses get quick access to funds.
2. In factoring collateral is not required to access funds. So, businesses don't have to put their assets as security.
3. In factoring business doesn't have to worry about collecting payment of unpaid invoices from customers.
4. It is easy to get access to funds in factoring than traditional financing options and It does not require a strong credit score.
debt factoring financing definition
A factoring in which a business sells its account receivables at discount rates to a third party in exchange for immediate cash is known as debt factoring.
When is debt factoring used?
When businesses have a high amount of accounts receivable but don't have enough working capital to sustain their business and they don't want to wait for customers to pay their invoices. In this type of case debt factoring is used.
factoring companies for small businesses
Fundbox
Lendio
Riviera Finance
Triumph Business Capital
Example of a Factoring Transaction
Suppose you want to sell your invoices worth $10000 to a factoring company. Then the factoring company may give you 75% ( 75000 )in advance and 5% ( 500 )after collecting payment from the customers and the rest of the 20% ( 2000 ) is charged as a factoring fee.
Read more:
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