When obtaining business loans, many companies may hear the term “factoring.” But what exactly is the definition of factoring? Factoring, also known as accounts receivable financing, is a transaction where businesses sell their accounts receivables, or outstanding invoices, to a commercial third party financial company. This third party is known as the factor. This enables businesses to quickly receive cash, allowing them to avoid waiting the standard 30- to 60-day collection period.
Business factoring differs between financial service providers. Factoring companies purchase invoices, advancing businesses’ money within twenty-four hours. Advances are purchased for less than face value, generally for 80- to 95-percent of invoice values. This percentage usually depends on customers’ credit histories and other financing criteria.
The third party factor provides office support, collecting money from customers and then paying businesses the reserve balances of the remainder on the invoices, minus any fees for assuming all collection risks.
The main benefit of factoring is that businesses can immediately have cash, instead of waiting several months for funds. Businesses can take this cash to pay operating expenses and grow their businesses.
The advantages to factoring helps to boost businesses’ cash flow, resolve short-term cash flow shortages and helps businesses grow their operations by spending money on marketing, advertising or new employees. Other significant benefits of factoring include:
- Factoring is easy to manage and customize, helping to provide capital when companies are in need.
- The financing never shows up on balance sheets as debt, because the invoices have been purchased.
- It is generally based on customers’ credit, not on business’ credit or histories. High-risk customers are a greater risk for factors.
- It offers a line of credit that is based on sales, not a business’ net worth.
- Unlike conventional loans, factoring does not have limits on financing amounts.
- It is ideal for start-up businesses that require immediate cash flow.
Companies of all sizes participate in factoring to help increase their cash flow. Factoring for businesses is common among several types of industries, including the transportation industry, textiles, oil and gas, manufacturing and distribution and staffing agencies.
Factoring companies vary with fee structures and some require additional costs for shipping, money transfers, collateral and other business-related costs. Most factoring contracts are renewed on an annual basis.