What is Factoring? Definition and Benefits of Factoring for Small Businesses

In this article:

• The definition of factoring
• What is meant by the term “factoring” for small businesses?
• What are the benefits of factoring?
• How to find the right factoring company

In the complex world of business finance, “factoring” has emerged as a valuable tool for small business owners seeking flexible solutions to their cash flow challenges. Factoring, often described as “accounts receivable factoring” or “invoice factoring,” offers a lifeline to struggling businesses by converting outstanding invoices into immediate working capital. But what exactly is factoring, and how can it benefit your business? In this article, we’ll explore how factoring works and highlight the advantages it holds for businesses of all sizes. Whether you’re a small startup navigating your initial growth phases or an established company aiming to optimize your cash flow, understanding factoring is essential to unlocking new financial possibilities. Join us as we demystify the world of factoring and illuminate the path to financial flexibility and success.

What is factoring?

Factoring describes a type of accounts receivable (AR) financing that allows borrowers to exchange their unpaid invoices at a third party factoring company for a cash advance. A company’s accounts receivable balance is the amount of money the business is owed by clients and customers for goods or services already sold. AR is listed on a business’s balance sheet in the asset section. The account receivable balance is considered a highly liquid asset that should be able to be converted to cash quickly. However, many business owners struggle to collect on the balances, making the unpaid invoices a burden instead of an asset. For business owners that don’t want to or don’t care to collect on their accounts receivable balances, factoring is a great way to meet short-term cash flow needs. The most common type of factoring is called discount factoring, which is when a business sells invoices for a predetermined amount of funds less a commission, or factoring fee.

How factoring works is:

1. The business submits their unpaid invoices to a factoring company
2. The factoring company advances 80-90% of the invoices value to the business
3. The factoring company collects the money owed on the invoice
4. The factoring company pays back the company the remaining 10-20%, minus factoring fees

What’s the difference between factoring and invoice financing?

It is important to differentiate factoring from business lending. Factoring is not a loan, it’s a unique financing arrangement designed to provide a means for business owners to receive a lump sum of cash upfront in exchange for uncollected receivables.

Factoring should not be confused with invoice financing. With factoring, you are selling your invoices to a factoring company. With invoice financing, you are taking out a loan or line of credit against your unpaid invoices, which are used as collateral.

Invoice factoring should also not be confused with a merchant cash advance (MCA), a form of alternate funding which uses a business’s future credit card sales to secure funding.

What are the benefits of factoring?

Factoring intimidates many business owners because of the hefty financing costs. Business owners that are able to collect their receivables directly do not have to be concerned with a factor rate, interest rates, or origination fees, however, they carry the risk of not collecting at all. So let’s look at some of the benefits of factoring:

• Cash flow – Factoring provides a fast-funding option for small business owners that need immediate capital to cover operating costs, expand their business, launch a marketing campaign, or make a large purchase. Factoring, and other short-term loans, are also popular with businesses that experience regular cash flow fluctuations, like seasonal industries.
• Creditworthiness – Since the cash advance is secured with unrelated parties’ debts, factoring companies have little interest in a borrower’s creditworthiness. New business owners or those with bad credit scores benefit from being able to secure capital without the pressures of strict credit eligibility requirements.
• Efficiency – Factoring requires that accounts receivable be sold at a discount, calculated using the factoring company’s terms and predetermined factor rate. However, when the unpaid balances become cash, the business owner saves time and money. Receiving a fraction of the invoices upfront allows business owners to save time and money spent in collection efforts.

How to find the right factoring company

Business owners interested in working with a factoring company should start with examining the factoring company’s reputation, pricing, specialties, and terms. Some questions to ask when researching factoring companies include:

• Is there a certain size or type of business the factoring company works typically works with?
• What is the average collection time of the factoring company?
• What documents are required from borrowers?
• What is the process for invoices deemed uncollectable by the factoring company?
• What are the factor rates and fees for factoring?
• What percentage of the total amount purchased will the borrower receive upfront?
• Is there a minimum, or maximum, number of invoices the company will purchase?

Takeaways

Factoring may be a good choice for you if you have a lot of unpaid invoices but need cash right away. While you may pay higher fees than you would with a traditional loan, you get fast capital with flexible credit requirements and no obligation to collect sold AR balances. Each factoring company is unique, so work with a small business lending expert to find the right financing solution.