An Overview of Factoring and how it Works
Factoring or ‘Debt Factoring’ is an asset management product or a financing method that allows for accounts receivable or longer payment terms with invoices to be traded as a valuable asset to meet the working capital requirements of a business.
It is intended to help improve the cash flow of an enterprise that has slow-paying invoices. Factoring involves a financial product that is an enabler in selling unpaid invoices (accounts receivable) to a third-party factoring company (a factor).
Invoice factoring is gaining prominence as an alternative business funding method because it converts invoices due within 90 days into immediate cash for businesses of different scale.
Suppliers can enjoy highly competitive interest rates with factoring.
Factoring helps address the working capital challenges faced by businesses while using traditional financing products from banks and other financial institutions.
Businesses that can benefit from Factoring
Invoice factoring is just as effective for small businesses and start-ups, as it is for larger companies. A business may be eligible for factoring based on the following factors:
- The size and origin of the invoices being traded for
- Time frames
- Potential risks
- Credit score and reputation of the supplier
This last factor is less important since the real risk for the factor lies with the credibility of the business that has to settle the invoice.
Debt factoring can be ideal for brand new businesses, start-ups and even companies with poor credit, as a means of generating working capital more effectively. The rates may simply be slightly higher for less established businesses, or those with bad credit.
What are the charges for Factoring?
The components of the charges for factoring differ depending on aspects including the value of invoices being raised, the supplier’s company size (factoring invoices for larger companies or small enterprises), and the expected level of risk for the factoring company (the lender).
The costs include a service charge, and the discounting or factoring fee (discount rate) itself. There may also be additional fees for services like credit protection, or charges for pre-empted end of the service. On average, factors will charge 0.5 – 5 percent of the total value of the factored invoices, per month.
The base cost (without additional fees) of an invoice factor depends on two things:
Discount rate (or factor rate): This defines the primary cost of borrowing money from the factor and is typically charged on a weekly or monthly basis. Many factors offer a tiered system for their discount rates, so the more a business factors in a month, the lower the discount rate offered.
Length of factoring period (the time it takes your customer to pay): Discount rates are charged at regular intervals (usually weekly or monthly) and is influenced by the length of time it takes for the customer to pay the invoice.
Some of the additional fees that companies can expect include:
Origination fees: Fees for initiating a new factoring relationship and opening an account
Incremental fee: If a flat discount rate is charged, then an incremental fee may be charged to increase the total discount paid to the factor as an invoice ages. This fee can range from 0.35% to 1%.
Service fee or lockbox fee: This is a flat fee that your factor may charge you to keep a lockbox (like a designated account for the factored invoices to be paid by customers) functional.
Collection of overdue fees: Your factor may charge you for the efforts put into collecting past due payments from your customers. Some will even charge you a flat fee for any payment that becomes past due. These fees depend on the factor.
Unused line fee: If you keep a portion of a factoring facility unused for a given month, this fee may be charged. It is typically quoted as a percentage and charged every month ranging from 0.15% to 0.5%.
Monthly minimum volume fee: If a certain level of fees is not generated for your factor in a given month, they may charge a minimum volume fee. This depends on the factoring company’s policies.
Renewal fee: An annual fee of up to 1% of the factoring facility size charged for the renewal of services.
ACH transaction fee: A fee charged for every advance or disbursement issued from the factor to the supplier of the invoice.
Wire fee: This fee is charged if a request to receive a wire is raised by the supplier instead of an ACH, which is the preferred method of payment by most factors.
Credit check fees: This is a small fee passed on by the factor to the invoice supplier for any credit checks they have done on the supplier or their customers.
Three Important Aspects Factors are Concerned About
- Who you invoice: Usually, factors prefer business-to-business (B2B) or government (B2G) customers. Customers need to have good credit scores and they need to be established businesses. The factor will need to be convinced that your customers are likely to pay off your invoice.
- Due date of invoices: Factors usually prefer invoices that are due and payable within 90 days and unencumbered by other loans.
- Reliable Credit history: Your business should not have a history of serious tax or legal problems.
How Factoring Works?
Usually, a factoring company has its platform backed by financers where the supplier can create an account after meeting the basic qualifications. After creating an account, the Supplier submits the pending digital invoices (account receivables) with the buyer for approval. Most factoring companies purchase invoices in two instalments.
The factoring advance is paid out on the first instalment and covers about 80% of the receivable (this amount varies). The remaining 20%, less the factoring fee, is rebated in the second instalment as soon as your client pays the invoice in full.
The two important steps in setting up the account are:
Step #1: Finding a factoring company
Begin the process by looking for a reliable and experienced company that can meet your cash flow needs. It is important to look for the one that has experience in the industry relevant to your business and has worked with customers similar to yours.
Step #2: Setting up a factoring account
You need to set up an account on the platform of the factoring company. The contract and all legal documents need to be reviewed carefully. A factor will check the supplier’s eligibility status to receive financing and conduct the due diligence on the customers being invoiced to see if they are good credit risks.
Once a financing agreement is signed, the factor must send out the notices of assignment which states that your company has authorized the factor to receive future payments for invoices you issue is sent by the buyer to your customers.
A lockbox account (like a designated account for the factored invoices to be paid) is maintained to receive all payments that is set up by the factor.
This process can take between one to three days, depending on how fast the paperwork gets done.
The next few steps delineate the factoring process
Step #3: Invoice the Client
Once you have issued an invoice to your customers for your products or services, must ensure that these invoices will be payable within 90 days to be eligible for debt factoring.
Step #4: Submission of Invoices
Usually, invoice suppliers sell their receivables to the factor by submitting them with a schedule of accounts. The schedule of accounts lists the invoices that need to be sold.
The factor then verifies the invoices in the Schedule of Accounts. Once the Buyer approves the invoices and submits additional documents like GRN, the invoices are shared with Financers on the platform for bidding. The supplier can choose the financer based on the discount offers provided by them and the best bid. The buyer then sends the advance to the supplier which is the amount disbursed by the financer chosen. The advance is the first instalment of the purchase and ranges from 70% to 80% of the gross value of your invoice.
Most suppliers get their funds via direct deposit, also known as an ACH.
Step #5: Getting the Rebate
The factor settles the rebate which is the second instalment of the transaction and may cover 5% to 30% of the invoice. This depends on the percentage of the initial advance and the way the factoring company decides to handle the rebate component. Some factors distribute the rebate when the customer pays in full. Others “batch” rebates and provide them on a weekly, monthly, or any other basis.
Step #6: Collection from Customers
The factoring company will purchase the unpaid invoices for a percentage of its value and then take over the debt collection process. The pending amount owed to your business for the invoices will then be repaid once the factoring company has collected the total value of the invoices from your customers. The evaluation of the creditworthiness of your customers and scheduling reminders are handled by the factor.
Step#7: Paying the Remaining Amount
Once the complete invoice payment has been collected from the customer, the factor will pay you the remaining balance of your money (reserve amount) before the due date, minus their fee. The buyer waits for the credit period to get over to pay the outstanding amount to the Financier.
Simply put, businesses facing problems in invoice settlements from clients can expedite access to funds and incoming cash flow with factoring which is a reliable instrument and a game-changer in the collection process.
Factoring helps businesses free up time and resources from the in-house accounts receivable and collections department by taking over the complete credit control management and ensuring timely payments.
Businesses can use the expertise of accounts receivable (AR) management professionals by just registering on a Factoring platform that will take care of the entire process based on eligibility.