At least 30% of the small companies and businesses around the world experience late or unpaid invoices. It has multiple negative effects and it makes it harder for companies to deal with payroll, investments, supplier payments, manufacturing payments, etc. But there are ways you can avoid these problems.
Factoring shows up when a company or business sells its accounts receivable invoices to other companies or financiers at a discount. Now the question is, why would any company sell their invoices for less than what they owe?
The short answer is, need for immediate cash flow. Sometimes short-term debts require you to have cash on hand. So it will be a good idea to sell your invoices to receive immediate cash to deal with short-term needs.
It is a position where no business wants to be in, but it is a useful tool when there is a need for immediate cash flow.
Let’s take a look at an example, imagine a company named A, sold its products to its customer for $50,000 with payment due in 30 days. But A has to pay $30,000 to the suppliers within 20 days. As you can see, A needs immediate cash.
So, A sold its invoices to a Factoring company for $45,000 and received the cash. Now A can make the payment to its suppliers and reduce risks. This is how factoring works.
What is Factoring?
Factoring, or sometimes known as invoice discounting, is a financial tool that is commonly used by businesses and companies. When a company or business sells products or services, they usually favor the payment terms of their customers.
And most of the time they don’t receive their payments at the time of the sale. There are many reasons why most companies accept the payment terms of their customers. It helps in building trust and good business relationships between businesses and customers.
Moreover, it increases the sales over time. When such transactions happen, businesses and companies are left with account receivables that only hold the unpaid invoices of their customers. The invoices remain unpaid until the customers pay them.
Factoring refers to a financial agreement between a factor (organizations that buy receivables) and a business or company. A business usually receives advances in exchange for receivables from a factor.
What is a Factoring Company?
Factoring companies are specialized in invoice financing for small and medium-sized businesses or companies that are non-bankable. Factoring companies offer financing services to businesses and companies that need immediate cash flow due to slow-paying invoices.
Factoring companies usually purchase your accounts receivables at a small discount and give you immediate funds.
That is very helpful in solving immediate cash flow problems. Most factoring companies pay up to 90% of your invoices immediately and pay you the remaining minus their fee when your customers pay in full.
Woking with factoring companies is one of the most popular ways to deal with cash flow problems due to slow-paying customers.
There is one more thing that people often get confused about factoring companies that they lend money to businesses or companies. But actually, what they do is, they purchase the invoices of a company at a small discount and pay them immediately.
Here are some of the basic requirement of factoring companies:
- List of products or items that your company sells
- Must have creditworthy customers
- You have limited access to bank
- A business bank account
- Tax id
- A form of Personal id
How does a Factoring Company work?
Factoring companies are specialized in invoice factoring and purchasing the outstanding invoices of businesses and companies. Most businesses that have slow-paying customers or businesses that are looking for immediate cash for financial needs go with factoring companies.
Factoring companies purchase businesses’ receivables at small discounts and provide them immediate funds. Businesses don’t have to wait for months to get paid by their customers. Once they purchase the invoices, they directly collect the cash from the business’s customers.
Factoring companies don’t work with every industry. Many of them focus on specific industries such as manufacturing, wholesale, technology, courier service, office supply, distributors, food service, etc.
Many banks offer factoring services, but most of the factoring institutions are private. And most private factoring companies offer flexible rates so you will have a better chance to get affordable rates.
Advantages of Working with a Factoring Company:
Most businesses and companies work with factoring companies because it offers immediate funds for selling unpaid invoices. But there are other factors that you can take into consideration:
Improved Cash Flow:
Most of the factoring companies offer your immediate funds against your unpaid invoices. It is better than waiting for the money to come in from your customers.
It improves your business’s cash flow and helps you with your business plans. You will be able to avoid potential risks by paying the due payments on time.
Helps You Avoid Bank Loans:
Factoring companies are usually cheaper than traditional bank loans. It is also far easier to obtain which makes it best for short-term financial needs. There is no need to worry about repaying your interests from time to time as well.
Helps Your Business to Last Longer:
Cash flow plays a major role in the survival of your business. Many businesses fail just because of poor cash flow. Factoring companies offer you the cheapest and easiest way to maintain a good cash flow.
Improves Business’s Financial Strength:
Factoring companies make it possible for businesses to deal with their financial problems with their own receivables. Your collection time will be decreased as well as your payables. It makes your business’s financial structure stronger. The best part is you will be able to use your business resources to deal with financial needs.
Helps to Build Good Connection with Your Suppliers:
Factoring companies provide you immediate funds in exchange for your receivables. You can use those funds to pay your suppliers on time or even faster.
Since you pay your dues on time, your suppliers would like to work with you longer. And they might offer your discounts in the future as well.
Easy to Apply:
The application process is easier compared to other forms of traditional lending. Most companies or businesses that have a trustworthy customer base and don’t have any major problems can apply without any issues.
How to Choose the Best Factoring Company?
Most factoring companies are not the same. Most of them are specialized in different industries. They also offer different terms, rates and take different factors into a consideration.
Finding the best factoring company that suits your needs and situation is not easy. Take these points into a consideration before going with a factoring company:
- Their experience in this business
- Their terms, fees, and funding limits
- How fast they provide funds?
- How do they deal with your customers for unpaid invoices?
- How they are getting their funds?
Always compare the rates of factoring companies to find the best ones. If you are thinking about whether you should go with a company that is near you or a company that is far from your location but offers good rates. The distance doesn’t really matter. Because all the transactions will be done online or via mail.
How does a Factoring Company make money?
When a business or a company sells their receivables to factoring companies, they advance up to 90% of the unpaid invoice value to the business or company.
Once the factoring company collects the full payment from the business’s customers, they return the remaining 10% to the business minus their factoring fee. The factoring fee depends on company to company. Let’s take a look at how factoring companies make money:
Let’s assume, A is a clothing company and wants to sell its $1 million worth of invoices to a factoring company named B. B agreed to pay $900,000 in advance with a 4% discount.
So once A’s customer pays his unpaid invoices to B, B will return the remaining $100,000 minus the 4%. So B will make $40,000. This is how factoring companies make money.
How Much do Factoring Companies Charge?
The cost of factoring mostly depends on the financing volume and the quality of your unpaid invoices. Generally, fees start from 1.15% to 3.5% each month.
Also, your fee varies from company to company and your industry. Here is a list of the average fee of a factoring company:
- 3% each month or 1% per 10 days
- 1.5% each month or 0.5% per 10 days
- 2% per 45 days or 0.5% per 15 days
In order to reach your business goals, you need cash. You will need a good cash flow for your employees, suppliers, business campaigns, buying equipment, etc. But the problem is your customers don’t pay you when you need them to pay. You may receive invoices that don’t get paid for the next 30-60 days.
And this is how your goals slip further away day by day. This is when factoring companies come up. They are one of the best ways to get paid against your unpaid invoices. It gives you immediate access to cash that you can use to grow your business.