Running a business often requires creative approaches to facilitate cash flow. With fluctuating sales during seasonal periods and competitive, ever-changing markets, you may find yourself looking for alternative methods for financial stability.

What Is a Factor?

A factor is an intermediary agent that provides cash or financing to companies by purchasing their accounts receivables. In short, a factor is a funding source; the factor agrees to pay the company the value of an invoice—less a discount for commission and fees.

Factoring can help companies improve their short-term cash needs by selling their receivables in return for an injection of cash from the factoring company. The practice is also known as factoring, factoring finance, and accounts receivable financing.

Key Takeaways

The terms and conditions set by a factor may vary depending on its internal practices. The factor is more concerned with the creditworthiness of the invoiced party than the company from which it has purchased the receivable.

What is factoring and how does it work?

At the end of the fiscal year, you’ll likely find that your business has a few unpaid invoices from clients. You’ve tried to chase them up and been hit with silence from their end. This can hurt your growth plans, outstanding debts, and supplier costs. Is your only option for chasing up these invoices to engage in a costly and lengthy legal procedure which may end up in court?

Thankfully, you have other options. This is where factoring comes in.

Factoring is the process of selling these outstanding invoices to a financier or ‘factor’. You sell the invoice at a discounted rate, lower than the money owed on the invoice. The factoring firm makes a profit by then chasing up the client to whom the unpaid invoice is addressed and charging them the full amount.

What are the types of factoring?

There are two major types of factoring which will be useful to you depending on your immediate situation. Let’s go through both so you can best understand for yourself how to proceed with factoring.

Recourse factoring

Recourse factoring is essentially factoring with a consequence for you as the business owner. When you enter into an agreement with a factoring company, you will decide on what happens if, after purchasing from you the unpaid invoice,  the factor fails to receive the funds from the client. In recourse factoring, the factor can then come back to you and request another invoice of similar value, which you will have to pay for.

Non-recourse factoring

Under a non-recourse factoring contract, the factoring company must absorb the losses if the client fails to pay the invoice. Non-recourse factoring protects you and your business when selling unpaid invoices to a factoring company, in the event that your client goes out of business before paying their debts.

What are the benefits of factoring?

During tax time, factoring can be a hugely beneficial way to balance your tax return by obtaining some quick cash.

Control your financing

Having unpaid debts from clientele gives you a warped picture of your business finances. You’ve previously accounted and adjusted for these payments and when they don’t show up, it throws things into a bit of a spin. By selling these invoices at a lower price to factoring companies, you can reform the picture of your finances you initially accounted for. Factoring also helps with reliable cash flows, equity, and liquidity. By selling the invoices, money comes in almost immediately and you can begin to make adjustments to address cash flow problems caused by the unpaid debts.

Maintain a positive financial reputation

If you’ve had a particularly bad year with unpaid invoices, perhaps through many clients or a couple of projects that took a great deal of time and resources, this can seriously damage your financial reputation. It can affect your chances of applying for a line, a healthy line of credit, and even lead to bankruptcy.

With factoring, you can curb a lot of these problems. It won’t solve them entirely, but the damage to your business’s reputation will be far less severe.

What are the risks of factoring?

Despite providing quick cash in tricky situations and improving cash flows, factoring does come with some risks which are worth considering.

Losing control

Factoring is essentially relinquishing control of your finances. You are invoicing the responsibility of cash collection to a third party. This can have a negative impact on your customer relations. Factoring companies are likely to be more aggressive in their approach to cash collection and when this is being done on your behalf, your relationship with a customer who has failed to pay one invoice may suffer. Your methods may alienate this customer and potentially word will spread, resulting in a reputation you had no control over.

Recourse factoring

Make sure you carefully consider your decision to go with recourse factoring. As mentioned above, recourse factoring puts the responsibility back on you if the factoring company cannot receive payment from the client. You will receive a fine and be left with an unpaid invoice that the client is clearly very unlikely to repay. Many factoring companies only offer this option, so make sure you know what you’re getting into.

Your financial reputation

Despite factoring being an efficient way of balancing your books around tax time, it does have consequences for your reputation. Customers can see when you’ve outsourced invoicing instead of collecting the invoices, which can send the message that your business has trouble collecting invoices on a normal schedule. This may affect your assessments from lending companies, who will distrust your stability as a business. You may also see a reduction in credit limits when applying for company or personal credit cards, as well as reduced timeframes payment timeframes on certain accounts.

Additional offerings

Factoring may be the only service you need at the time, but certain companies will offer additional services that could be useful. Having a broader selection of financial offerings to choose from can be a helpful little surprise that could end up strengthening your company’s financial reputation further. Factoring companies offer additional services like:

• Inventory borrowing

• Loans

• Accounts receivable factoring

Choosing a factoring company

There are a lot of things to consider when selecting a factoring company. How you choose will determine the kind of experience you have with factoring, and ultimately will affect your company’s financial situation at a crucial time.

Factoring company reputation

True to entering any business relationship, you should always do a background check on the factoring company you choose. Things you should determine about the company include:

• How long the company has been in business

• Customer reviews

• Which companies, businesses, and freelancers they have worked with

• Their affiliation with a financial association

• Ethics, responsibilities, especially ones in line with your own

Agreement terms

You might be drawn immediately to a factoring firm with the lowest rates, but there’s more to consider. Factoring companies will include certain agreement terms that alter the conditions of the relationship you enter into. Make sure you’re totally clear and in agreement on the following:

• Recourse or non-recourse factoring

• Repayment schedules

• Advance rates

• Cancellation fees

• Contract lengths

Hopefully, factoring isn’t something you will need to do regularly. However, should you need to do it, make sure you approach it in a way that maximises its benefits for you and your business. Understanding both the benefits and risks involved will lead to a more informed decision, especially when selecting the right factoring company for you.

The Bottom Line

A factor can act as a source of funding for a company. A factor is usually a financial institution; it agrees to pay a company the value of its outstanding invoices—less a discount for commission and fees. This practice is called factoring, or accounts receivable financing. The factoring company will set specific terms and conditions, depending on the risk involved in the transaction.

The practice of factoring is beneficial because it allows a company to boost its cash flow in the short term. For a factoring company, these transactions are beneficial because they earn a factoring fee for each transaction. Most factoring companies take between 1% and 5% of the total amount of the invoice value, but this amount can vary based on the factoring volume, client creditworthiness, business stability, and other considerations.