What is factoring? Everything you need to know

If you are a business owner looking for ways to improve cash flow and manage accounts receivable more effectively, then gaining a thorough understanding of factoring is sure to benefit both you and your business.

Let’s dive straight in…

What is factoring?

Factoring refers to the practice of selling your business’s invoices to a third party at a reduced price. This gives you immediate access to cash while the factoring company handles collecting payment from your customers.

Factoring can therefore be beneficial for small and medium-sized businesses in industries with long payment terms such as manufacturing, distribution and staffing, as it helps improve cash flow and working capital management.

What type of business should use factoring?

Factoring is popular with businesses that have large sums tied up in outstanding invoices and are looking to enhance their cash flow. It is therefore most appropriate for small and medium-sized enterprises.

Industries such as manufacturing, transportation, staffing, and wholesale distribution often employ factoring, because these are typically sectors with long payment terms, leaving the business out of pocket until they receive customer payment.

Some have a misconception that factoring is a funding line of “last resort”, reserved for businesses that cannot manage their cash flow effectively on their own, but this is far from the truth. Increasingly, savvy business owners are employing factoring to unlock the capital already tied up in their business – in their outstanding invoices. Leveraging capital in this way gives them accelerated access to cash, enabling them to invest sooner in growth initiatives, as well as simply maintaining cash flow.

Advantages of factoring:

Immediate impact on cash flow

Factoring offers businesses an immediate injection of cash, bridging the gap between sending a customer their invoice and receiving payment.

This provides businesses with the liquidity needed to meet financial obligations such as payroll and rent, but can also unlock funds for more long term growth opportunities. Investing in new equipment, bolstering inventory and capitalizing on early payment discounts offered by suppliers are all activities that are difficult to implement without readily available capital – factoring simply frees up what is already there.

Debt, but not as you know it

Unlike a traditional loan, factoring does not burden a business with “debt” in the conventional sense. While factoring is a form of debt finance, it does not require a business to meet a monthly repayment schedule, as the lender is repaid when the customer makes payment of the outstanding invoice.

This can make it a great way to raise additional capital without the time and resource needed to manage a loan.

No need for collateral

One of the major advantages of factoring is that lenders consider the outstanding invoices as collateral.

Unlike traditional loans, where collateral is often a key part of the eligibility criteria, factoring focuses on the creditworthiness of a company’s customers instead. This can make it an excellent option for small or growing businesses that have won contracts with great clients – and perhaps even need to raise capital to be able to support these contracts – but that have limited assets to offer as collateral for a conventional loan.

Higher credit limits

Usually a lender will rely heavily on credit history to evaluate a business’s eligibility for a loan, but with factoring, the credit limit offered to a business is usually based on the value of its accounts receivable, including its invoices.

Where a business has large sums tied up in outstanding invoices, this often means that they can access more cash sooner than would be available from a conventional lender. This is because the business is simply leveraging the capital already tied up in their business and are using it to accelerate their access to cash, so they can reinvest it as they see fit.

Disadvantages of factoring:

Although factoring offers numerous advantages for businesses, it is important to consider its drawbacks.

Cost of factoring

One notable disadvantage is the cost associated with factoring, especially for businesses with narrow profit margins and/or where the lender’s risk exposure is high.

Businesses should weigh up the benefits of having faster access to cash against the cost of doing so. Often, where the cash is to be used to support growth (including enhancing cash flow to free up capital for growth initiatives), the cost of factoring is outweighed by the long term growth uplift it offers the business, but firms should assess the impact of factoring on their individual situation.

Customer relationships

Often, customers will need to change payment details so they pay the lender rather than the business, which reveals to the customer that the business is using a third party lender. Some customers may wrongly interpret this as a sign of the business’s financial instability, which naturally makes business leaders nervous about using invoice factoring.

Some lenders will offer confidential facilities, however, which means the business receives all the benefits of accelerated capital, without needing to reveal to their customers that they’re using a factor.

Factoring – An important tool for growth

Factoring can be a valuable financial tool for businesses looking to improve cash flow and free up working capital. It provides immediate access to funds, eliminates the need for collateral and offers higher credit limits than might otherwise be available to a business.

To learn more about how working capital solutions such as factoring can benefit your business, book a chat with a member of our expert team, explore our website, or even apply online to receive a quick indication as to your eligibility.