In a factoring arrangement, the business sells its right to receive the cash in the future to a factoring company. The factoring company pays the invoice amount to the business and the right to receive the cash from customers is transferred to them.
The practice of factoring is carried out to meet the present and prompt money needs as opposed to hanging tight for installment dependent on the terms of the invoice.
An efficient practice of factoring results in effective liquidity management by ensuring availability of cash resulting in smooth efficiency of the operations.
How does factoring work?
The business model of factoring is based on the idea of selling receivables. For instance, you own a business with limited capital, deploy the capital in the purchase of the stock, the stock is sold, and as per deal receipt will be made after 90 days.
Although, it was a profitable deal by agreeing the credit period of 90 days you are left with no capital to run the business. The situation might put a full stop on business operation for 90 days to wait for the period to end and collection to be made. This results in suffering for the business.
To avoid the situation, the practice of factoring is was introduced where the factoring company provides funds to the business and obtains contractual right to receive the cash from business customers. The business gets funds immediately to continue the operations.
The business model of factoring companies
The factoring companies do not usually provide the full amount of the invoice factored. They provide funds to the business after deducting their charges.
For instance, the business wants to factor in an invoice amounting to USD 100,000 which is the amount to be received from the business customer.
The factoring company will enter into a contract with the business where it will obtain contractual power to collect the USD 100,000 and provide immediate funds to the business amounting to USD 95,000. The difference of USD 5,000 is the actual fee of the factoring fee.
The fee of the factoring company might differ for different invoices depending on the time remaining in the collection, reputation of the business, the credit rating of the customer, and other factors. Further, the type of factoring also plays an important role in the determination of the fee.
Let’s discuss the types of the factoring fee and how it affects the price of the factoring.
In non-recourse factoring, the factoring company does not have the right to recover funds from the business if the customer does not pay in the future.
The risk for bankruptcy of the customers is presumed by the factoring company. The price for non-recourse factoring is usually higher because the risk of customer default is presumed by the factoring company.
In recourse factoring, if the customer of the business does not pay the factoring company, the factoring company will be able to recover it from the business.
The risk of customer default is presumed by the business. The price for the recourse factoring is usually lower because the risk of the customer default is presumed by the business.
Benefits of factoring
Better liquidity management and adequacy of the cash flow
82% of the start-ups fail due to inefficient management of the cash flow. Cash flow management is more than a crucial factor for a successful run of the business.
The practice of factoring helps the business ineffective management of the cash flow by helping the business to get access with quick money.
The factoring company provides funds depending on the volume of the invoices to the business. The business can use the money as working capital or may allocate it for any other uses.
Hence, factoring helps businesses to get highly liquid funds and increases the adequacy of cash flow management.
Credit protection for the business
In the case of non-recourse factoring, the risk for the default of the customer is transferred to the factoring company. Hence, the business does not need to create provisions for bad debts.
In addition to this, the business owners and managers get psychological satisfaction that their profits are realized on a timely basis.
Ease of focus on the business operations
The collection of receivables is one of the toughest jobs in the world, it requires timely communication and regular follow-ups with the customers. It’s a time-consuming process that engages managers making them unable to focus on the core business perspective like strategic competence and growth.
The setting of the factoring agreement helps to take off the collection receivables from the to-do list of the managers, this enables them to focus on the strategic aspects of the business.
Higher bargaining power
Factoring optimizes the capital of the management which means the company can afford to sell on credit and purchase in cash. This increases the bargaining power of the business for the purchase and sale of the goods.
Further, the factoring facility does not require collateral or assets like traditional financing schemes which again makes it attractive.
Drawbacks of factoring
1) Deduction on invoice
The factoring company does not pay the full amount of invoice to the business. It deducts the fee for making an early payment.
Hence, continuous and prolong ease of factoring might put the business managers at ease and the company on a trend of reduction in profit.
2) Not all invoices are accepted
The factoring company may not be willing to accept all the invoices. They may only accept the invoices of the customers with a proven record of timely payments. This does not let the business take greater advantage of the factoring facility.
3) Customer might not be comfortable
The customer might not be comfortable paying for the invoices to the third party (factoring company) when it had a deal with the business.
It may be a cause of some concerns for the customers as they do not like buying patter/information to be shared with some third party. This may actually be a reason for losing customers.