Invoice factoring is an often cited but rarely implemented process that confers upon a company many advantages that not only improve the cash flow of the business but also the ability to manage said business. This article will discuss why companies should consider factoring, how it benefits them as well as the cost of doing so, and what nuances there are to factoring.
Factoring receivables involves the effective sale of a receivable to a factor for an amount less than the nominal value of the receivable. In effect a company is saying that they will sell to a factor a receivable for $100 for say $97, depending on the terms of the factoring agreement. For the $3 the company is giving up of the receivable they are avoiding collection risk, meaning that even if the customer defaults and doesn’t pay the bill the company is still paid for the receivable by the factor, and they also avoid the costs associated with pursuing and processing the receivable itself. As such, a real benefit is that a company that is handing off all of their receivables to a factor is able to decrease the size of their accounting staff and not need to hire an accounts receivable clerk or collections manager.
Further, a factoring arrangement will provide some additional security for a lender to the company which often leads to an increase in the amount that a company can borrow from a lender. Lenders like the factoring arrangement as it provides a third party check on sales and collections and decreases the risk of fraud. Many factors will then pay money directly to the lender as per the terms of the agreements entered into, which thereby decreases the risk that the borrower will ultimately default on the loan. Finally, factoring provides companies with more reliable cash flows which benefits the business, its management, and of course their lenders.
Beyond the cost of factoring receivables, the other major negative for many companies is that factors will often limit the customers to whom the company can sell to and prior approval is often needed before a new customer is sold to. As such, it may not make sense for some businesses to pursue a factoring relationship and those who do factor often need to be more conservative in their business practices, though many factors will often allow a business to have a certain amount of non factor sales.
Factoring receivables therefore makes sense for a lot of different companies looking for reliable cash flows and lower overhead, but the added cost and controls placed on a company can be burdensome to them.