How do Factoring Companies Work?

The term factoring in finance stands for the act of buying a company’s rights to collect payments from its debtors or accounts receivables and charging the company for this service. So, you can also call factoring accounts receivables financing. Factoring companies then are the companies who provide this service of collecting debts on behalf of their client company from the third party at a service fee.

Why would a business engage with a factoring company? Why won’t a business itself collect the accounts receivables and avoid paying the factoring company its fee? The answer to this is that factoring companies pay you usually within 24 hours of receiving your bills receivables invoice. So, factoring companies provide you instant cash flow solutions. Businesses in urgent need of cash due to some sudden developments can also approach factoring companies.

How do Factoring Companies Work?

Let’s break down how the factoring companies work into simple steps. To enhance our understanding let’s assume that Sam is the owner of a factoring company.

Client Comes

In the first step, a client comes to Sam with a bunch of bill receivables invoices. The client’s company provides goods and services to their trustworthy customers for credit. It takes the customers 60-90 days to make this payment. But Sam’s client needs the money immediately to keep his business running.

So, the client asks Sam to purchase all his bills receivables invoice and make him instant payment for the invoice’s worth. Sam tells him that his team will review all the bills receivables within the next 24 hours.

Verification

Sam’s verification team reviews all the bill receivables invoices. They do a background check and their job is to find out those customer’s ability to pay. Upon approval, one of the representatives in Sam’s factoring company gets in touch with the client. The representative informs the client about their terms and conditions for providing instant cash and collection service. He tells them as per their policy, they will advance about 90% of the invoices’ value now. the balance of 10% of the value of the invoice, net of their service fee, would be given after the collection of payment from the debtors.

Payment

Once the verification is complete and the client agrees to the terms and conditions outlined by Sam’s company, Sam’s team does the legal work, gets the required signature from the client, and advances the money immediately. After this, Sam’s factoring company become the legal beneficiary of the invoice’s value. The paperwork ensures and authorizes Sam’s company to collect the payment directly from the debtors on behalf of the client.

Collection

Once the bills receivables mature, Sam collects the full payment directly from the client’s customers. Once Sam receives the full amount from the debtors, he releases the remaining 10% of the amount of the bills minus his fee. Sometimes, the factoring companies have to chase some of the debtors. The riskier it seems to Sam’s team, the higher the fee they charge for factoring.

How do Factoring Companies Work

What Makes Factoring Companies Promising?

What makes businesses approach factoring companies? Why don’t they themselves collect the invoices? The answer is that in that case, the business will have to wait for the maturity of the invoices. Factoring companies, on the other hand, provides the cash against the receivables, usually within 24 hours, such an instant source of cash. It may be the case with your business that giving every customer a credit term of 60-90 days, in line with the standard market practice, can dry up your business out of cash. Hence, to support your day-to-day operations and keep the business running smoothly, factoring companies are a desirable route to encash the invoices.

Why use Factoring Companies as a source of funding? Why don’t businesses simply go to a bank and take a loan for the cashflow requirements? The answer is that it is less costly to factor in your invoices than to get a bank loan. Also, it is also a lot easier to factor in your invoices than to get a bank loan. Plus, a bank loan doesn’t take away the task of collecting money from debtors. You will have to pay interest on the bank loan and have still got to spend time and energy on collecting payments. Factoring companies on the other hand is a one-stop solution for both things.

Last but not the least, if you factor in your invoices, it will improve the morale of your people working in the accounts department as collecting payments from debtors is often stressful work. Your accounts people can then focus on their primary job responsibilities. Additionally, if you do a lot of business on credit, factoring will help you save the cost of a separate credit staff.

References

Sanjay Bulaki Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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