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How Does Factoring Work

How Does Factoring Work

If you are curious about how does factoring work to provide ready cash inflow into a business, this article will be an insightful read. Here you will find an explanation of how factoring works, in a nutshell.
Omkar Phatak
Last Updated: Jun 3, 2018
Maintaining a ready cash inflow and ensuring liquidity is an essential requirement for any business. It often happens that outstanding payments from customers make it difficult for any business to arrange for adequate liquidity inflow, that's necessary to keep the wheels of production moving. In such circumstances, a business may opt for short term loans or take advantage of its accumulated accounts receivable through the process of factoring, to bring in the much-needed cash. For those of you who are not familiar with the idea, this Buzzle article focuses on providing you with a simple explanation of how factoring works to provide immediate liquidity.
About Factoring
Factoring is something like taking a loan against the accumulated accounts receivable, though it falls short of actually being a loan. A business that has a substantial amount of invoices, with pending payments from customers, hands them over to a factoring company, which provides cash in advance, in return, which amount to 80% to 90% of the invoice value. For this service, they charge a fixed fee which is directly proportional to the amount and time delay of invoice payments. The remainder of invoice value is delivered to the business after factoring fees have been deducted.
How Does Factoring Work For a Business?
When short of working capital, a business can bank upon its accounts receivable or invoices to generate immediate liquidity. Factoring companies come to the rescue of businesses who are plagued with the problem of delayed customer payments.
Factoring as a business practice has been around for years as delayed payments is not a recent problem that businesses have started facing. Factoring companies (also known as factors) draw a service agreement with businesses who need immediate cash for their day-to-day operations. Under the agreement, a business submits its pending invoices to the factor, which are then verified for their authenticity. A valuation of the invoices is made and according to the terms of the agreement, a cash payment of 60% to 90% of the value is made to the business.
Under the agreement, customers directly pay the factor, instead of paying the business. On reception of full cash value of the invoices from the customers, the remaining 40% to 10% of the invoice value is returned to the business, after deduction of factor fees. These fees are not a constant and change according to delay involved in making invoice payments. For both, the business and factor, this process offers a win/win deal. Businesses don't have to resort to applying for loans to keep their business running and can cash in on their delayed payments immediately.
Let me present an example which will make it easy for you to comprehend how factoring works. Suppose that a business has accounts receivable amounting to $10,000. It hands over these invoices to a factor, who in return provides them with a 85% advance cash return by charging fees amounting to $500 for a forecasted payment period of six months. Thus the business receives $8500 in cash advance. After 6 months, once the customers have made a full payment of $10,000 to the factor, it returns ($1500 - $500) to the business, which amounts to $1000. Thus, instead of receiving $10,000 after six months, the business receives $8,500 instantly, which it can bank upon.
In this way, factoring provides businesses with an alternative of cashing in on their long term accounts receivable payments and keep things moving ahead. The obvious disadvantage of opting to factor accounts receivable invoices is the substantial amount of money the business loses in terms of fees paid. Still, for businesses with highly delayed payments from customers, factoring can save them from a situation, where production entirely comes to a standstill due to drying up of liquidity.
By paying fees to the factoring company, you pay for the time advantage that you gain through advance payments. Consider the pros and cons of opting for the services of a factoring company, before deciding to sign up an agreement. If you think that a short term loss through fees paid to the company is compensated by the amount of profits created through advance payments, factoring is a sensible thing to opt into. Go for reputed factoring companies with a good track record and check out the service agreement details carefully before signing up.