Invoice Financing

Factoring is a sort of debtor financing in which a company sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount. A company may factor its receivable assets in order to fulfil its current and immediate cash demands. Exporters that want to sell their receivables to a forfaiter utilise forfaiting as a factoring solution in international trade finance. 

Accounts receivable factoring, invoice factoring, and accounts receivable finance are all terms used to describe factoring. Accounts receivable finance is a more correct phrase for a type of asset-based lending backed by accounts receivable. The Commercial Finance Association is the industry’s premier trade group for asset-based lending and factoring.

Factoring is not the same as invoice discounting in the United States (which is referred to as an assignment of accounts receivable in American accounting, as defined by FASB within GAAP). Factoring is the sale of receivables, whereas invoice discounting (also known as “assignment of accounts receivable” in American accounting) is a type of borrowing in which the accounts receivable assets are used as collateral.

Factoring Definition

Factoring is a method of obtaining cash utilized by some businesses. 

Certain companies factor accounts when their available cash balance is insufficient to meet current obligations and other cash needs, such as new orders or contracts; in other industries, such as textiles or apparel, financially sound companies factor accounts simply because it is the traditional method of financing. 

Factoring to obtain the cash needed to meet a company’s immediate cash demands allows the company to keep a lower continuing cash balance. More money is available for investment in the firm’s growth by reducing the size of its cash holdings.

How does Invoice Factoring work?

The one who purchases the receivable, the one who sells the receivable, and the debtor who has a financial obligation to make a payment to the invoice owner are the three persons immediately engaged. 

The receivable is a financial asset that allows the owner of the receivable the legal right to collect money from the debtor whose financial liability directly corresponds to the receivable asset. It is frequently coupled with an invoice for work completed or items sold. To collect cash, the seller sells the receivables at a discount to a third party, a specialized financial institution (also known as a factor). When a company’s immediate need for raw materials exceeds its available cash and capacity to acquire “on account,” this procedure is often used.

B2B enterprises employ invoice discounting and factoring to guarantee they have the cash flow they need to meet their current and urgent obligations. Factoring is not a viable financing option for retail or B2C businesses because they rarely have business or commercial clients, which is a need for factoring.

The sale of a receivable gives the factor possession of the receivable, signifying that the factor now owns all of the receivable’s rights.

As a result, the receivable asset becomes the factor’s asset, and the factor acquires the right to receive the debtor’s payments for the invoice amount, as well as the freedom to pledge or swap the receivable asset without unjustified limits or restrictions. The account debtor is typically told of the sale of the receivable, and the factor bills the debtor and handles all collections; however, non-notification factoring, in which the client (seller) collects the accounts sold to the factor as the factor’s agent, is also possible. 

The debtor is normally kept in the dark about the assignment of the receivable, and the seller of the receivable collects the bill on the factor’s behalf. If the receivable is factored “without recourse,” the factor (receivable purchaser) is responsible for the loss if the account debtor does not pay the invoice amount. The factor has the right to collect the unpaid invoice amount from the transferor if the factoring transfers the receivable “with recourse” (seller).

However, any merchandise returns that reduce the invoice amount collectible from the accounts receivable are typically the seller’s responsibility, and the factor will typically hold back payment to the seller for a portion of the receivable being sold (the “factor’s holdback receivable”) in order to cover the merchandise returns associated with the factored receivables until the privilege to return the merchandise expires.

Factoring Process

The two elements of the factoring operation are the initial account setup and ongoing funding. To start a factoring account, you’ll need an application, a list of clients, an accounts receivable ageing report, and a sample invoice. It usually takes one to two weeks. 

The approval process includes extensive underwriting, during which the factoring company may require additional documents including incorporation documentation, financial statements, and bank statements. If the application is approved, the company will be allocated a credit limit from which to borrow. 

Under notification factoring, the agreement is not confidential, and approval is contingent on successful notification; this is a process in which factoring companies delivers a 

Notice of Assignment to the company’s client or account debtor.

The goal of the Assignment Notice is to notify debtors that a factoring company is handling all of the company’s receivables, make a claim on the financial rights for the receivables factored, and change the payment address, which is commonly a bank lock box.

Once the account is set up, the company can begin funding bills. Individual invoices are still authorised on a case-by-case basis, however most invoices can be funded in a day or two if they fulfil the factor’s requirements. 

Receivables are split into two categories. The “advance,” which covers 80 percent to 85 percent of the invoice value, is the first part. This money is deposited into the company’s bank account. Once the invoice is paid in full to the factoring company, the remaining 15% to 20% is refunded, less the factoring fees.

Debt Factoring

Debt factoring is also used as a financial tool to improve cash flow control, particularly when a company has a large number of accounts receivables with varying credit terms to handle. When a corporation calculates that it would be better off using the funds to enhance its own growth than than effectively operating as its “customer’s bank,” it sells its invoices at a discount to their face value. 

As a result, factoring happens when the rate of return on capital invested in production exceeds the expenses of factoring receivables. As a result, the trade-off between the firm’s return on investment in production vs the expense of using a factor is critical in deciding both the level of factoring and the amount of cash on hand.

Many firms have a fluctuating financial flow. It could be rather enormous in one period and quite little in another. As a result, businesses find it important to keep a cash balance on hand as well as adopt strategies like factoring to fulfil their short-term financial demands when cash flow is insufficient. Each company must then decide how much it wants to rely on factoring to address cash flow shortfalls, as well as how large of a cash balance it wants to keep to guarantee it has adequate cash on hand during periods of low cash flow.

In general, the variability of a company’s cash flow will affect the amount of its cash balance and the extent to which it will have to rely on financial processes like factoring. The extent to which cash flow can shift and the length of time cash flow can be below average are both directly related to cash flow variability.

Cash Flow Factoring Loans

If cash flow is expected to fall dramatically, the company will require huge sums of cash from existing cash reserves or a factor to meet its obligations during this time. Similarly, the longer a period of relatively low cash flow lasts, the more cash from another source (cash balances or a component) is required to meet the company’s obligations at that time. As previously stated, the company must weigh the opportunity cost of losing a return on funds that could otherwise be invested against the costs of factoring.

A company’s cash balance is essentially a desire for transaction money. As previously stated, the size of the cash balance a company chose to keep is directly proportional to its willingness to pay the expenses associated with using a factor to finance its short-term cash needs. The challenge that the company confronts in determining the size of the cash balance it wants to keep on hand is similar to the problem it encounters in determining how much physical inventory it should keep on hand. In this case, the company must weigh the expense of getting cash proceeds from a factor against the opportunity cost of losing the rate of return it obtains on its investment.

What are factoring payments?    

Factoring is a sort of debtor financing in which a company sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount. A company may factor its receivable assets in order to fulfil its current and immediate cash demands.

What is factoring of debt?    

Debt factoring is the practise of a company selling its invoices to a third party at a discounted rate in order to avoid the lengthy wait times connected with invoice payments.

Do factoring companies give loans?    

It’s worth repeating that most factoring companies don’t actually give you money; instead, they essentially buy your receivables at a discount, allowing you to get cash quickly.

Does factoring require collateral?    

This method, also known as accounts receivable factoring, involves treating invoices as collateral and selling them to factoring companies. Funding is accessible as long as you have bills to factor! For many business owners, working with a factoring company is a viable choice, but the lending market remains tight.

What is a good factoring rate?    

Factoring rates and advancements on average:

General Business 1.15% – 4.5% 70% – 85%

Staffing 1.15% – 3.5% 90% – 92%

Transportation 1.15% – 5% 90% – 96%

Medical 2.5% – 4% 60% – 80%