Factoring is when you sell an invoice for slightly less than what it’s worth to get instant cash.
It’s a unique way for businesses to take care of cash flow problems without the need for loans and other measures that could put them into debt. In addition to that, when a business sells an invoice, it no longer has to worry about collecting on that invoice, as the invoice purchaser takes over the collection process.
Here is an example using simple numbers.
Company A manufactures and supplies a component for Company B and bills them $5,000 and gives them 30 days to pay it. In the meantime, Company A finds that it needs some cash quickly to cover some kind of expense. So, Company A sells that $5,000 invoice to a Factoring Company for $4,500. Company A gets that $4,500 immediately and uses it to cover the aforementioned expense.
Within that 30-day period, the Factoring Company that purchased the invoice collects the full $5,000 from Company B. The Factoring Company then returns the remainder of the money to Company A, minus a small fee. Let’s say the Factoring Company keeps $100 for a fee. That means Company A gets $4,900 back from that original $5,000 invoice, plus Company A also got the convenience of receiving cash right away without having to wait the full 30 days or without having to collect the money itself.
There are a few different kinds of factoring. Let’s take a look at these.
Sometimes called supply chain financing, reverse factoring is essentially the same as regular factoring, except it is usually initiated by the other party. Generally, it will be the company that is doing the supplying of a product or service that initiates factoring. In reverse factoring, it is the company that is doing the ordering or purchasing.
A purchasing company may do this to ensure its suppliers can get paid as quickly as possible, which will help suppliers with their cash flow. It is especially attractive for purchasing companies that consistently use the same supplier and want to make sure that supplier is in good stead so it can continue to supply the purchasing company with whatever it is ordering.
Using the same numbers as above, here is an example.
Company A supplies Company B with a component and charges Company B $5,000 and gives them 30 days to pay. Company B then hires a Factoring Company to pay Company A immediately. The Factoring Company pays Company A the money owed to them minus a small fee.
Reverse factoring is typically only done by large companies that want to create good cash flow for their suppliers. It allows these companies to garner close relationships with their main core of supplier.
This is simply factoring done for one invoice at a time.
In this type of factoring, the company that sells the invoice can be held responsible if the party that owes money for the invoice is unable to pay it. The fees for this type of factoring are usually lower because the factoring company doesn’t take on as much risk.
In this type of factoring, the company that sells the invoice cannot be held responsible if the party that owes money for the invoice is unable to pay it. Since the factoring company takes on more risk, the fees for this type of factoring are usually higher.
Those are the main categories of factoring along with some examples. For small businesses and even large businesses sometimes, factoring can be a quick and convenient way to get cash quickly.
[Photo courtesy of Pictures of Money on Flickr]