Factoring, also known as accounts receivable factoring, is a financial tool that allows businesses to sell their outstanding invoices to a third party (the factor) to gain immediate access to capital. When a business provides goods or services, it issues an invoice with payment terms, creating an account receivable. Instead of waiting the full term for payment, a business can leverage factoring to improve its cash flow.
Here’s how it works: the factoring company purchases the invoice at a discounted rate, typically between 70% and 90% of its face value. The factoring company then collects the full invoice amount from the customer. The difference between the full amount and the initial payment, minus a factoring fee, represents the factor’s profit.
Factoring can be a strategic solution for businesses that offer credit terms to their customers. By selling invoices, businesses receive immediate payment, often within 24 to 48 hours, allowing them to extend competitive credit terms without straining their finances. Offering attractive credit options can attract more customers, especially for higher-priced goods or services where customers may prefer delayed payment options.
It’s important to understand that factoring is not a loan or debt. It doesn’t require collateral, unlike bank loans. Factoring is simply the sale of an asset – the invoice – for immediate cash. The business benefits from improved cash flow, while the factoring company assumes the responsibility of collecting the debt.
Many businesses use factoring to avoid the complexities and costs associated with managing collections. Factoring can eliminate the need for a dedicated billing department, resulting in cost savings. The freed-up resources can then be reinvested into other areas of the business.
The immediate cash generated through factoring empowers businesses to invest in new equipment, pay down existing debts, expand marketing initiatives, refine financial planning, streamline credit approvals, enhance customer relations, and reduce accounting expenses.