Factoring in financial management is one of the key concepts that businesses need to consider if they are looking for quick cash flow for growth and expansion purposes. By availing of this type of financing, a business can sell its invoices to a third party or a factor. The factor pays around 70 to 90% (as agreed between both parties) of the total invoice amount to the business immediately. It pays the balance amount to the business after it receives the payment from the customers. This helps the business to regulate its cash flow and keep its operations running. Hence, factoring in financial management plays a big role in the operations of businesses, especially the small and medium ones.
The mechanism of factoring finance can be best understood with an example -
a) Suppose, a business (X) sells goods worth Rs.10,000 to its customers. It sells these invoices to a factor (Y) because it needs quick money for its transactions.
b) Y will purchase the invoices and deduct 5% of this amount towards its commission. This rate is decided between both parties and is usually between 3 to 5%.
c) So, Y earns Rs.500 commission from this transaction. On the remaining amount of Rs.9500, Y may agree to pay 80% immediately and the remaining 20% after X has received its money from its customers as per the payment cycle.
d) In this case, Y pays X 80% of Rs.9,500, which is Rs.7600 immediately.
Discussed below are some of the major types of factoring services that are available to businesses today -
Recourse and Non-Recourse Factoring
These are the most popular types of factoring finance. In recourse factoring, the factor only accepts the invoices from its client (a business). It doesn’t take ownership in case customers don’t pay the business on time. That credit risk rests with the business only. However, in non-recourse factoring, the factor assumes this credit risk. If customers don’t pay on time, a factor cannot recover this amount from the business, as it has assumed responsibility for customer defaults.
In this type of factoring finance, the factor takes full control of the transaction. Apart from purchasing the invoices from the business, the factor maintains the sales ledgers of the business, tracks payment from customers, sends regular updates to the business about the transactions and takes the credit risk in case of customer defaults as well. These types of factoring in financial services are also known as Old Line Factoring.
Spot and Regular Factoring
In spot factoring transactions, a business sells its invoices to a factor for only one or a specific transaction. However, in regular factoring, the relationship between both parties is ongoing. Also, in regular factoring in finance, the factor sets an approved limit to be paid to the business in exchange for buying its invoices.
Maturity and Advance Factoring
In maturing factoring in finance, businesses sell the bulk of their invoices to a factor. The factor agrees to pay a certain percentage of the invoice amount to the business on the maturity date of these invoices, or on a specified due date. In advance factoring, however, a factor pays a bulk amount (around 75 to 90% of the invoice amount) to the business within 2 days of buying the invoices, thereby helping it to arrange for quick cash flow.
Disclosed and Non-Disclosed Factoring
In disclosed factoring, also known as bulk or notified factoring, the factor reveals the factoring deal to the buyer (customers of the business). The customers pay the money to the factor directly. In a non-disclosed or confidential factoring agreement, the buyer is not aware of the factoring finance deal between the business and the factor.
Bank Participation Factoring
When a bank also joins with the factor in lending money to a business, it is called bank participation factoring. In this case, a factor pays around 80% of the invoice amount to the business, and the bank may lend a loan to the business for the remaining 20%, to meet its operational expenses.
In limited or selective factoring, a factor doesn’t buy all the invoices from a business. It selects invoices based on the creditworthiness of the buyers.
Supplier Guarantee Factoring
Here, a factor pays the bulk amount not to the business but to its supplier, so that the business can buy its raw materials or meet huge demands without any delays.
In this case, a customer arranges or initiates a factor for the business from where it purchases its goods/ services. This happens when a customer is a big enterprise, but the business is only small-sized.
Given the wide range of factoring in finance, one may get confused about which type of factoring finance is best suited for their business. In such a situation, it is best recommended to take advisory services from business and finance experts like Finverv.
Given below are brief pointers about the advantages of factoring
Quick cash flow for small and medium businesses
Better financial planning and sales ledger management
Helps businesses to evaluate the creditworthiness of their customers
No burden of credit risk, when choosing non-recourse factoring
Great financing system, when planning for business expansions
Some of the major disadvantages of factoring are -
Commission or discount charges will impact profit margins for businesses
Factoring service is not available for all invoices in most cases
In case of payment defaults from customers, businesses need to face extra burdens while paying off factors
Direct dealings of factors with the customers may affect the reputation of the business
While factoring finance is a great way to get quick cash flow for a business, it is always a good idea to go through the factoring advantages and disadvantages in great detail when choosing the right type of factoring. Businesses must choose only that type where the advantages of factoring outweigh the demerits so that it can be a win-win deal for them and their customers.