Factoring, also called debt factoring, is a process by which a business sells invoices to third parties. In exchange, these third parties allow funds to be drawn against money owed to the business. Providing debt collection, finance, and ledger management services, factors (as the third parties are called) are used commonly by businesses for improved cash flow but they can also function in reducing administrative costs. Factoring is available in two types: recourse and non recourse factoring.
Why opt for factoring?
Factoring, whether recourse or non recourse factoring, starts when you sell your invoices to a factor. This way, you are taking advantage of fast prepayment in order for you to enjoy improved cash flow and increased working capital. Think of it this way: if a customer has credit terms with you, you don’t automatically collect money when you make a sale, unlike in cash transactions. The customer may pay you before the end of his credit terms but this is highly unlikely so you more or less let a couple of months pass until you can collect payment. And within those couple of months, it would seem like your customer is enjoying your products and your services for free. This shouldn’t matter really but it can be a concern if you don’t have a lot of working capital. Of course, you rely on every sale you make. But if a sale doesn’t actually convert into money immediately, then it’s useless to you.
What factoring can do for you?
Whether you use recourse or non recourse factoring, factoring essentially means that every sale you have will be converted to actual money in your pockets as factors cover the costs of each approved sale you have. This means no more waiting for credit terms to end before you can collect payment since factors already paid you in essence. When credit terms end, your customers then divert payments to your factor. You should also be paid whatever balances are left at the end of the credit terms since customers will pay factors in full. It depends on the factor but it is typical for advances to total 85% of the approved invoices. Payments from the factor are usually made available within 24 hours. Keep in mind though that factors will take a percentage of the total invoices. This is how they make money on their end as they provide factoring services to you.
Recourse factoring vs. non recourse factoring
When you use recourse factoring, this means that factors will not take on risks of bad debts. Should a customer not pay at all, factors can take back the money they paid you. Using non recourse factoring, on the other hand, puts bad debt risk on the factor but will not insure against unpaid transactions arising from genuine disputes. As the non recourse option puts factors at more risk, it will cost you more to use this option. All terms and conditions between you and a factor will be stipulated in a factoring agreement.