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Factoring involves a financial institution providing an advance on a company’s outstanding invoices. Essentially, a company sells its accounts receivable to a factor (a bank or financial company), which provides immediate cash that the company can use for its operations, in exchange for a fee.
Put simply: Customers owe you money, and the bank or factoring company says “OK, we’ll advance this so that the company gets the money immediately in exchange for a fee that goes to the bank.”
The bank or the factoring company takes on the risk and responsibility of collecting the money if the customers do not pay.
How does factoring work?
When a company sells a product or service and issues an invoice, that invoice might not be paid immediately by the customer. A factoring company can step in to provide the invoiced amount, or a significant portion of it, to the company up front. The factoring company then takes on the role of collecting the payment from the customer.
The company benefits from improved cash flow since it doesn’t have to wait for the customers to pay their bills. In return for advancing the cash, the factoring company charges a service fee and assumes the risk if a customer fails to pay.
Why do businesses use factoring?
The primary reason businesses use factoring is to improve their current liquidity. It gives cash flow, making it possible for the business to cover operational expenses such as payroll and supplier bills without waiting for customers to pay.
While factoring is a useful tool for many businesses, it is not a service available for everyone. Financial institutions often have criteria that need to be met before offering this service.
Difference between factoring and invoice sales
Even though it very similar, there are differences between factoring and invoice sales. Factoring contracts typically cover all of a business’s invoices, providing a steady cash flow solution. On the other hand, invoice sales generally involve selling individual invoices, one at a time.
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Advantages and disadvantages of factoring
Businesses often use factoring to increase their available cash. This can help them pay expenses more promptly and avoid cash flow issues.
Can provide higher liquidity
Factoring can provide improved liquidity for the businness. Other benefit are reduced credit risk, and less administrative effort. A potential challenge is the cost of the service which could impact overall profits. This is a factor your business should think about before using factoring.
Mostly used in B2B
Factoring is mostly used in B2B (business-to-business) transactions. This is allowing businesses to continue operations without waiting for invoices to be paid, which can often take longer than in direct consumer sales.