Your manufacturing company has received a large contract, shipped a large batch of goods with a deferred payment. The second major client made an order immediately after this transaction and your company definitely does not want to lose this client.
At the same time, you are short on cash to purchase the materials necessary to produce the goods for the second order because the first one will pay only after a couple of months. What can you do? You can try to get a loan for your business or you can use accounts receivable factoring and get money faster, easier, and without collateral.
What is it?
Accounts receivable factoring is the exchange of future earnings for money. In other words, you sold the item on a deferred payment basis and issued an invoice to the customer. This invoice is a promise of your future revenue, but you haven’t received the money from the buyer yet. The factoring company takes this invoice and pays it before your buyer does. This is how an intermediary factor appears in settlements between the seller and the client. Obviously, such services are not provided on a free basis and fees are involved.
Factoring was first used back in the 14th century in England in the textile industry. The factors not only established relationships with potential buyers but also dealt with the collection of the sales revenue. Modern factors are not directly involved in finding and building relationships with clients, but indirectly help in the receivables collection process, since they provide access to working capital and allow both parties to maintain liquidity in trade relations.
The active growth of the factoring services occurred in the United States at the end of the 19th century. The factors acted as intermediaries for German, British and local textile suppliers. Factoring companies acted as a guarantor of payment for all goods for suppliers and took a commission from them for the risk of non-payment. Over time, factoring became a much more widespread service.
Why use factoring?
- Attract clientsThe ability to pay later is a great benefit for your client. By offering the client comfortable payment terms, you can get ahead of your competitors. With the help of accounts receivable factoring, you can release goods or provide services on a delayed basis without fear of cash shortages: the revenue will come to your business as soon as you make the sale and this money can be used immediately.
- Scale your turnoverThanks to the improved working capital at the expense of factoring, it is possible to expand the client base, the range of goods and, as a result, increase income. You can have larger inventory during the high season or enter new markets.
- Reduce risksAccounts receivable are always a risk. A customer who paid on time last year suddenly started delaying payments this year or a new customer asks to sell goods on credit, but you are not sure that they will pay for the item. There are factoring options that help reduce the risk of default. After the factor provides financing, it will remind the buyer about the payment obligation and terms. Factoring can free your business from the risks of non-payment and cash gaps. The risks of non-fulfillment of payment obligations by the buyer completely transfer to the factor, which makes your business more sustainable.
- Keep good financial indicatorsThe accounts receivable factoring is not considered to be a loan, so the company’s financial reports will not be negatively affected neither by the large accounts receivable numbers nor by the loans that a company would need to otherwise take to maintain a good level of working capital. This is a great advantage if the company wants to attract investors or needs to take on a loan for business expansion or other purposes.
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How does it work?
The classic factoring scheme looks quite simple.
- The supplier ships the product to the buyer on a deferred payment basis.
- The invoices are sent to the factoring company, which, in turn, pays the company from 50% to 90% of the buyer’s debt based on the invoices for the shipped goods. The portion of this amount depends on the size of the transaction, the duration of the payment deferral, the risks associated with the transaction, and the amount of goods shipped.
- Later, the buyer pays the amount of money equal to the value of the goods supplied by the company on a credit basis to the account of the factoring company.
- After that, the accounts receivable factoring company transfers the remaining amount to the business.
The most common type of factoring is non-recourse. In this case, the factor gets the right to claim the debt, while the business receives money and can use the funds as it wants. Even if the debtor does not return the money later, this will not affect the business that used factoring services in any way. The factor will remind the debtor of the need to pay, collect money through the court, and takes other actions along with the risks. Accordingly, such factoring services cost more money.
A recourse type of factoring is used less frequently. The factor also gets the right to claim the debt, while the business receives money and can use the funds as it wants. But if the debtor does not transfer funds to the factor on time, the burden of payment falls on the business. This means that the business that uses the accounts receivable factoring services will have to:
- return the funds that the factoring services gave it (usually, they are withdrawn from the working capital or even assets are sold)
- contact the buyer (write letters, sue, collect evidence) to get the money owed.
Recourse factoring is less risky for the factor, so this service is cheaper. The factoring company will in any case receive the money: either from the buyer who was supposed to pay under the contract or from the business who was supposed to be paid.
You can also distinguish two other types of factoring services. In one case, The buyer knows that a third party, a factoring company, is involved in the transaction. The payment documents indicate that the rights to the resulting receivables are transferred to the factoring company and must be paid according to the payment terms specified by the factor.
In the other case, which is usually more preferable, the buyer is not aware of the existence of the factoring company. The seller can provide the factor’s bank account information on the payment documents. When the buyer pays the debt, the factor makes a mutual settlement with the seller, taking into account the commission the business pays for the services provided.
Author: Charles Lutwidge