Factoring and its benefits
There are various methods to decrease credit risk as a precautionary measure with factoring being one of them. It is a financial tool by which a factor (third party) will advance monies against a percentage of an invoice raised. However, this is not to be confused with invoice discounting which is a slightly different option. Another term for factoring is accounts receivable financing with factoring being the advance payment of part of the invoices.
Factoring is of benefit for those businesses that need immediate capital and cash flow for business operations to fulfil their immediate financial commitments. The payment period for invoices can normally range anywhere between 30 – 120 days. As this is a lengthy timeline it can have a direct impact on business operations including meeting monthly overhead costs including rent, salaries and paying suppliers to name but a few.
Let us examine the advantages of factoring:
- Helps to increase cash flow.
- The company’s credit history is not examined. With factoring, it is the credit history of the customer.
- Gives extra time to promote business development as cash collection is taken care of by factoring.
- Since factoring does not involve a loan no debt is incurred with no addition of interest.
- It is scalable with an increase in business, the funds can also increase as it is usually based on a percentage of the turnover.
- It can be used when an extra input of cash is needed for the business.
When a seller uses a factoring company the latter generally advances a part of the invoice within 24 hours. It provides cash to the seller that helps in business operations. Generally, the percentage is anywhere between 80-90% of the invoice total. It is subject to certain specifics like the industry, credit history of customers and the individual chosen as the factor.
Three groups make up the process:
Factor – the individual that advances payment against the invoices.
Seller – The person that sells the invoice.
Debtor – They are obliged to make the invoice payment.
It is the responsibility of the seller to ensure debtors pay the invoices to the factoring company and they will be ultimately liable for any bad debts.