What is Factoring: Debt & Invoice Factoring
Factoring is a method of quickly increasing the liquidity in your company. Many countries operate on a supply and invoice system, leaving the company cash poor until the invoice is paid. Some clients are good at settling their invoices, but others take their time. This can quickly cause a cash flow issue for the supplying company.
One method of overcoming this issue is by using factoring, which we explain in more detail below. Proper financial management of your company is also essential, and Penta makes it easy with features such as built-in business expense management.
What is Factoring
Factoring is the process of selling your outstanding invoices to a third party, the factor, at a discount. The customer must then pay the factor instead of you. The amount you receive from the factor for your invoices will vary, but they will take a percentage as their profit.
There are several reasons for factoring, which we explore below.
How does Factoring Work?
Imagine your running your own successful business, but cash flow is a continuous problem. You’re busy completing orders and issuing invoices, but still, the company never seems to have enough cash.
This is where factoring may be an option.
Instead of waiting for your customers to pay you, you can turn to a factor. You decide to sell your outstanding invoices to a factor that will pay you the majority of your invoice value and give you that vital cash flow.
Now the debt is between your customer and the factor, whose job is to collect the outstanding amount. Once the invoice is settled, the factor often pays you an additional amount.
Factoring: An Example
Consider an office furniture company, Office Supplies Inc, has an outstanding account receivable from the Big Insurance Company that recently refurbished their offices. The invoice is for €100,000, and the factor negotiates a discount of 5% on the total invoice value.
The factor will pay Office Supplies Inc an advance of €75,000, with the remaining €20,000 paid when the factor receives the invoiced amount of €100,000 from the Big Insurance Company.
The difference of €5,000 is the discount the factor arranged with Office Supplies Inc and represents their fees and commission in the deal.
Benefits of Factoring
There are many reasons a company may choose factoring for its invoices.
- Cash flow. One of the biggest reasons for companies failing is cash flow. A business with a full order book and plenty of customers can quickly get into trouble without liquidity. Factoring your invoices provides a cash injection for a small discount.
- Removes the burden of chasing customers for payment. Late payment not only causes a business financial harm, but it also requires someone to be actively pursuing them. This is an additional cost that offsets the cost of invoice factoring.
Downsides to Factoring
- You are passing your customer details to another company. It’s improbable that the factor is interested in taking your customers, but there is a data protection issue involved. In the era of GDPR, data protection, within the EU countries particularly, must be considered. It is imperative to check the company you are using for factoring is fully GDPR compliant. You must also have permission to share your customer’s details.
- An expensive way to finance your business. Factoring is not the cheapest way of funding your business. Maybe a corporate loan is a better option? The loan will be more competitive, but you still need to get your invoices paid. It’s a balance between the cost of factoring and the convenience it provides.
Factoring can be a useful tool for a company to boost its cash flow quickly. The upside is that the company can use the cash almost straight away, as the factor will typically provide an advance of most of the invoice value. The downside is that it’s a more expensive option than taking a loan. Small to medium companies (SMEs) may not have the opportunity of loans or overdrafts, but using a Penta Business Account for your SME can help with your financial management.
What is a Factor?
A factor is an intermediary. They operate between a customer and you, the supplying company. In effect, they provide business funding by agreeing to pay you a percentage of the invoice value, keeping the difference as their profit. The benefit to you is that you receive the majority of the invoice value right away.
What is Factoring?
There are several terms to describe factoring, such as factoring finance and accounts receivable financing. Factoring exists to provide businesses with cash flow.
The factor’s role is between the customer and the supplying business. The supplying business sells the invoice to the factor at a discount, and the factor advances an agreed proportion of the invoice value to the supplying company immediately. On receipt of the invoice value from the customer, the factor will pay the remaining invoice value, less the arranged discount.
Is factoring cost-effective?
Invoice factoring, or debt factoring as it’s also known, may be a cost-effective option for your company. If you need cash to continue operating, then the higher cost of factoring is justifiable. Otherwise, a short-term loan or overdraft may be a better option.