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Factoring, a particular type of debtor finance, involves a business transferring its accounts receivable, or invoices, to a third party entity, known as a factor, for a lesser value. This mechanism is utilized by companies aiming to fulfill their immediate and ongoing cash requirements. A specific type of factoring, named forfaiting, is preferred by exporters engaged in international trade finance who desire to offload their receivables to a forfaiter. Factoring goes by various names such as invoice factoring, accounts receivable factoring, and sometimes accounts receivable financing, the latter being a more appropriate term to describe asset-based lending against accounts receivable. The Commercial Finance Association spearheads the asset-based lending and factoring sectors.

In the context of the United States, it is crucial to differentiate factoring from invoice discounting, also known as an assignment of accounts receivable per American accounting standards, as defined by FASB within GAAP. Factoring implies the outright sale of receivables, while invoice discounting, or "assignment of accounts receivable," refers to a loan that is secured against the accounts receivable assets. Conversely, in some markets like the UK, invoice discounting is categorized under factoring and is included in the "assignment of receivables" as per official factoring records.

Thus, it is not recognized as a form of borrowing in the UK. Often, the arrangement is kept confidential in the UK, and the debtor remains unaware of the receivable's assignment, with the seller collecting the debt on behalf of the factor. The primary distinguishing factor between factoring and invoice discounting in the UK is confidentiality. However, Scottish law deviates from the rest of the UK, requiring notification to the account debtor for the assignment to occur. This position was reviewed by the Scottish Law Commission, which made proposals to the Scottish Ministers in 2018.

Details about factoring in finance

In a factoring scenario, three primary parties are involved: the factor, the entity that purchases the receivable, the seller of the receivable, and the debtor, who bears a financial obligation leading to a payment to the invoice's owner. Generally tied to an invoice for services rendered or goods supplied, the receivable represents a financial asset. It bestows upon its owner the legal authority to demand payment from the debtor, whose financial obligation aligns directly with the receivable asset.

To obtain liquidity, the seller transfers the receivables to a specialized financial organization, or the factor, at a discounted rate. This method is often adopted in manufacturing sectors when the immediate requirement for raw materials exceeds their accessible funds and capacity to buy "on account". Invoice discounting and factoring are strategies employed by B2B companies to maintain the immediate cash flow needed to fulfill their current and immediate commitments. However, invoice factoring doesn't serve as a feasible financing alternative for retail or B2C companies since they usually lack business or commercial clients, a pre-requisite for factoring.

Upon selling the receivable, the ownership transfers to the factor, thereby providing the factor with all associated rights of the receivables. Thus, the receivable converts into the factor's asset, and the factor acquires the right to receive the payments from the debtor for the invoice amount. The factor can pledge or exchange the receivable asset without any unreasonable hindrances or restrictions. In most instances, the debtor is informed of the receivable's sale, and the factor issues the bills to the debtor and manages all collections.

However, in some cases, non-notification factoring takes place where the client (seller) collects the accounts sold to the factor, acting as the factor's agent. The arrangement is usually confidential, and the debtor is unaware of the receivable's assignment, with the seller collecting the debt on behalf of the factor.

If the factoring is "without recourse," the factor (receivable's purchaser) must absorb the loss if the debtor fails to pay the invoice amount. On the contrary, if the factoring is "with recourse," the factor can demand the unpaid invoice amount from the seller (transferor). However, any returns of goods that may decrease the collectible invoice amount from the accounts receivable are typically the seller's responsibility. The factor usually delays paying the seller a portion of the receivable being sold (known as the "factor's holdback receivable") to cover the goods returns related to the factored receivables until the privilege to return the merchandise expires.

Rationale of financial factoring

Factoring serves as a cash acquisition strategy employed by certain enterprises. Some companies resort to factoring their accounts when their cash reserves are inadequate to fulfill current liabilities and manage other cash demands such as new deals or contracts. In some sectors, like textiles or apparel, financially stable businesses utilize factoring merely because it's the traditional financing method.

Leveraging factoring to secure the cash required to satisfy an enterprise's immediate cash needs allows the enterprise to maintain a smaller, ongoing cash balance. By reducing cash balance size, additional funds can be freed up for investment into the company's expansion.

Debt factoring also functions as a financial tool for enhanced cash flow management, particularly beneficial for a company with a significant number of account receivables across varying credit terms. When a company determines that investing the proceeds for its own growth will yield better results than essentially operating as its "customer's bank," it sells its invoices at a discounted face value.

Factoring comes into play when the return on investment in production surpasses the costs associated with receivables factoring. Thus, the balance between the returns earned from production investments and the cost of employing a factor becomes critical in deciding the extent of factoring usage and the amount of cash the firm retains on hand.

Many enterprises experience fluctuating cash flow. It may be significantly high during one period and relatively low in another. Hence, businesses find it imperative to maintain a cash balance and employ strategies like factoring to meet short-term cash needs during periods where these exceed the cash flow. Each business must determine its dependence on factoring to bridge cash deficits and the size of the cash balance it aims to maintain to ensure enough funds during periods of low cash flow.

Typically, the variability in cash flow influences the cash balance size a business prefers to maintain and the degree of dependence it might have on financial mechanisms such as factoring. Two factors directly contribute to cash flow variability:

1. The potential magnitude of cash flow alterations, and

2. The duration for which cash flow can persist at a below-average level.

If cash flow experiences a drastic decline, the business will need large sums of cash either from existing balances or a factor to meet its obligations during this period. Similarly, the longer the cash flow remains relatively low, the more cash is needed from another source (cash balances or a factor) to fulfill its obligations. As suggested, the business must weigh the opportunity cost of missing a return on the cash it could have otherwise invested against the costs associated with factoring utilization.

Factoring process

The process of factoring can be divided into two key stages: the establishment of the factoring account and the sustained funding phase. The account setup usually takes around one to two weeks and requires the submission of an application, a client roster, an aged accounts receivable report, and a representative invoice. The approval stage involves comprehensive underwriting where the factoring company may request further documentation, such as incorporation certificates, financial reports, and bank statements. If approved, the business will receive a maximum credit line from which it can draw funds.

In the scenario of notification factoring, the setup is not confidential and the approval depends on a successful notification. This is a process wherein factoring companies send the business's customer or account debtor a Notice of Assignment. This notice serves multiple purposes:

• It informs the debtors that a factoring company now manages all of the business's receivables.

• It stakes a claim on the financial rights of the factored receivables.

• It provides an updated payment address, typically a bank lockbox.

Once the account has been established, the business can start funding invoices. While invoices are still individually approved, most of them can be funded within a couple of business days provided they meet the factor's criteria. The funding of receivables happens in two stages. The initial phase involves the "advance", covering 80% to 85% of the invoice value, which is directly deposited into the business's bank account. The remaining 15% to 20%, deducted by the factoring fees, is refunded once the invoice is paid in full to the factoring company.

Accounts Receivable Financing vs Invoice Factoring​

Maintaining a robust cash flow is essential for any thriving business. There are certain services, known as "invoice factoring" and "accounts receivable financing", which can help boost short-term liquidity. These solutions can be beneficial if your business involves issuing invoices with payment terms that don't include immediate payment. These services can provide you upfront financing based on various criteria.

Here's an explanation of each to help you determine if they're suitable for your business financing requirements.

When to Consider Invoice Factoring or Accounts Receivable Financing

These services are designed to aid businesses that have to wait for invoice payments. If your business model involves upfront payment before delivery of goods or services, or immediate payment post-delivery, these options aren't applicable. However, if your payment cycles usually span days, weeks, or even months, these services can help bridge the financial gap between issuing invoices and seeing the money reflected in your bank account.

Understanding Invoice Factoring

In the process of invoice factoring, a factoring company purchases your pending invoices and provides you with a lump sum payment. The process involves:

• You hold unpaid invoices, which are expected to be cleared by your clients.

• You contract with a factoring firm to purchase these invoices.

• The factoring firm "acquires" these invoices, giving you an upfront lump sum.

• This lump sum is generally a fraction of the total invoice value.

The factoring firm takes over the collection process, interacting with your customers, including requests for payment and late payment penalties.

Once the invoices are cleared, the factoring company gives you the remaining amount, after subtracting their factoring or discount fee.

For instance, consider this scenario:

• You have unpaid invoices amounting to $10,000.

• The factoring firm imposes a 4% fee, equating to $400.

• From the remaining $9,600, they advance you 80% of the value, i.e., $7,680.

• When the invoices get paid, they transfer the remaining amount, which is $1,920.

• Any additional payments will be deducted from this final sum.

Factoring Fees

The fee that a factoring company charges can vary and depends on:

• The number of unpaid invoices.

• The total value of unpaid invoices.

• The sales volume of your business.

• The industry you're part of.

• The creditworthiness of your customers.

• Who is liable for uncollected invoices (you or the factoring firm).

Certain factoring firms charge an initial fee, while others may charge interest on outstanding invoices. The most prevalent type of fee is a "tiered factoring fee". Under this setup, the factoring company imposes interest on the value and the duration of the outstanding invoices. These fees could be in the range of 1.5 percent to 2 percent per month.

Charges for Accounts Receivable Financing

The interest rates applied to invoice financing can considerably fluctuate. They could be as low as 1 to 1.5 percent per month, escalating to 3 to 5 percent per month. These rates depend on various factors, including the number and value of your invoices, the industry in which your business operates, prior loans, the credit rating of your customers, and other elements.

Choosing Between Invoice Factoring and Accounts Receivable Financing

Your choice between these two services depends on your business requirements and your preferred mode of settling the payment.

If you wish to maintain control over the payment procedure, accounts receivable financing would be more suitable.

If you want to delegate the responsibility of payment collection to a third party, you might find invoice factoring to be an appropriate choice.

If your preference is for regular payments, then accounts receivable financing is the better option.

If you desire for your debt to be subtracted from your due business payments, and to receive the remaining amount (minus a fee) when your clients pay, invoice factoring would suit your needs.

Considering Other Options

Both these alternatives might turn out to be pricey due to fairly high fees. Therefore, other solutions might prove to be more cost-effective. At Connect2Capital, we offer specialized loan matching services for startups and small businesses. The interest rates associated with these loans often tend to be lower than those charged by factoring or accounts receivable financing firms.

Newly established companies might find it challenging to secure invoice factoring or accounts receivable financing due to their lack of cash flow or repayment history. While existing businesses may gain access to these services, we'd still suggest exploring business loans and making a cost comparison.

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