Factoring is a type of financial transaction in which a business sells its expected revenue streams or other assets to a third party (known as a “factor”) at a discount in exchange for immediate payments. Factoring may include purchase order factoring, invoice factoring and even structured settlements and royalties.
It is a tremendous tactic for quickly improving your cash flow situation during difficult times for your business. It is a great way to increase working capital for your operations while you wait for customer payments to come in. Factoring can be especially useful when your customer organizations have a better credit rating than you do.
Factoring is also a useful strategy for businesses that feature extreme swings in cash positions such as seasonal businesses like landscaping, tourism and hospitality companies.
It is also a very important financing and cash flow management strategy for companies doing business internationally. Large firms sometimes use factoring to show more cash on their balance sheets rather than account receivable entries.
Differentiating Between Factoring and Invoice Discounting
It is important for you to understand the difference between asset-based lending strategies like invoice discounting and getting payments from a factor for your invoice. Invoice discounting involves obtaining a bridge loan or short-term loan by borrowing on the asset value of unpaid invoices.
Third-party factors need to have a basis of assessing the value of the asset that they are paying you for. This is particularly true of non-recourse factoring where the factor has no recourse to come back to you if your debtor fails to pay them as promised.
By clearly understanding the attributes of such financing arrangements, you can increase your opportunities for getting the funding you need under terms that are favorable to you.
Here are the two most common ways that to leverage this important financing strategy.
Accounts Receivable Financing
As long as you do not have a “cash only” policy on the delivery of your products and services, you have accounts receivable assets. These are monies owed to you for what you have delivered to your customers. Before you can properly leverage accounts receivable financing, you must ensure that your invoicing system is efficient and effective, and that your customer selection is adequate.
For example, if your invoices don’t get sent out reliably, or if they are generally sent late, that could affect the asset value of your receivables overall. Furthermore, if you bill your customers without doing a great job of pre-qualifying them before service, you may find out that a significant percentage of your customers are high default risks.
Purchase Order Financing
When B2B or industrial customers complete a purchase order, these purchase orders can be used to obtain funding to pay for materials, suppliers, etc. Many factors will only offer funding to companies that have minimum monthly amounts that they need funding for.
In other words, you can make your factoring arrangements a strategic component of your on-going cash management system. Just note that purchase order financing may require the factor to dig into the credit worthiness of your customers, and maybe even the ability of your suppliers to deliver the goods.
When Factoring May Not Work
This may not be a great strategy for you if your margins on the sale of products are small, or if the financial reputation of your company among suppliers might take a hit due to the arrangement. Whether that applies to your company depends on variables like your past credit history, the confidentiality (or lack thereof) in your factoring agreements, the scale of your company and typical practices in your industry.
Source by Gogo Erekosima