Factoring is the progression of selling accounts receivable to an investor rather than waiting to gather the money from the customer.
Factoring has been around for thousands of years. Factors are investors who pay cash for the right to receive the future payments on your invoices.
An unpaid receivable or invoice has value. It is a debt your customer has agreed to pay in the near future.
Even though factoring deals completely with business-to-business transactions, a large percentage of the retail business uses a factoring principal. MasterCard, Visa, and American Express all use a form of factoring in their retail transactions. Using the purest definition of the word, these large consumer finance companies are actually just large factors of consumer paper.
Consider about it: You make a purchase at Sears and charge it to your MasterCard. The store gets paid almost straight away, even though you do not make payment until you are ready. For this service, the credit card company charges Sears a fee (typical fees range from two to four percent of the sale).
Factoring can offer many benefits to cash-hungry companies. Rather than wait 30, 60, 90 days or longer for payment on a product or service that has already been delivered, a business can factor (sell) its receivables for cash at a small discount off the amount of the invoice.
Payroll, marketing efforts, and working capital are just a few of the business needs that can be met with this instant cash.
Factoring provides the means for a manufacturer to refill list and make more products to sell: There is no longer a need to wait for earlier sales to be paid. Factoring is not just a cash management tool for manufacturers: Almost any type of business can advantage from factoring.
Normally, a business that extends credit will have 10 to 20 percent of its annual sales tied up in accounts receivable at any given time. Think for a moment about how much money is tied up in 60 days’ worth of invoices: You cannot pay the power bill or this week’s payroll with a customer’s invoice, but you can sell that invoice for the cash to meet that compulsion.
Factoring is a fast and easy process. The factor buys the invoice at a discount, more often than not a few percentage points less than the face value of the invoice.
People consider the discount a small cost of doing business. A four-percent discount for a 30-day invoice is common. Compared with the problem of not having cash when you need it to activate, the four-percent discount is insignificant. Look at the factor’s discount as though your business had offered the consumer a discount for paying cash. It works out the same.
Companies consider the discount the same way they treat a sales price: It is just the cost of generating cash flow; much like discounting products is the cost of generating sales.
Factoring is a cash flow tool used by a variety of businesses, not just those who are small or harassed. Numerous companies factor to reduce the overhead of their own accounting department. Others use factoring to generate cash, which can be used to expand marketing efforts and boost production.