This document explains how factoring is used to exchange receivables for cash.
You should carefully review the alternatives available to ease your cash flow, as factoring can turn out to be a considerable cost for the company. On a long-term basis this could mean adjusted company routines and changes in the structure of the organization. For acute cash flow problems, selling equity, taking loans on assets or trading credits with your suppliers are alternatives to factoring.
The purpose of factoring is to exchange receivables for cash by selling or pledging your accounts receivable to a factoring company (factor), that specializes in credit and collection.
Your receivables typically are tied up in the range of 30 to 60 days, sometimes even longer. By allowing a factoring company to give you cash in exchange for these receivables, you are immediately gaining a cash flow that can be used for more important business needs such as purchasing more inventory, paying taxes or reducing debt.
The advantages of factoring include cash availability, reduction of overhead and the possibility to offer credit terms to your customers in greater amounts. Factoring is mainly used by small, medium and growing companies. However, it is also becoming more prevalent among some large companies that operate worldwide.
Reasons for selecting factoring could include the need to finance rapid growth or new venture start-up or to meet fixed expenses such as payroll, regardless of seasonal fluctuations or economic business cycles. An additional reason is that you believe that by outsourcing your accounts receivable you will substantially reduce debt.
The standard workflow is this:
This includes establishing credit limits for your customers and practical cooperation between you and the factoring company.
A factoring company usually assumes the credit risk for any invoice it buys. In conventional factoring, the factoring company buys the invoice on a "without recourse" basis. This means that the factoring company does not require the client company to pay back the money advanced on amounts not collected for insolvency reasons.
You complete the sale to your customer, delivering the goods or service, and remit the invoice to the factoring company. The factoring company stamps the invoice stating that is has purchased the invoice, directing the customer to send payment to them. You could also notify the customer directly by sending a copy of the invoice with payment instructions to the customer.
After receiving the invoices, the factoring company pays you the invoices’ value minus the agreed factoring charge. This withheld amount is either a fixed charge per invoice or a percentage of the invoice amount and is adjusted for things like product returns. You reconcile the payment against the remitted invoices.
The factoring company submits the invoices to the customers, who pay directly to the factoring company.
This is very similar to using credit cards, since the credit card company functions as a factoring company.