How Does Factoring Work?

How Does Factoring Work?

Factoring Defined

For above four hundred years, businesses have been making use of factoring. Though it is often referred to as a loan, in fact it is not, as you’ll know on understanding how does factoring work.  Actually factoring refers to a business transaction that allows a business to sell its financial receivables to an intermediary, known as a “factor,” who pays the business directly, usually in the form of working capital, enabling the business to expand its activities. The business sells its financial receivables at certain discount.

How does factoring help businesses?

Businesses are encouraged to practice factoring as it enables them to get finance without any need to prove their credit worthiness that can be quite challenging, especially under tough economic circumstances. Factoring, needing no business plan or bank statements, is more convenient and quicker than availing a loan from any bank. In effect, factoring allows businesses to get rid of finance receivables that are most often a big source of irritation for a lot of business executives. On selling a product or a service, the businesses have to wait, at times for months, to get their bills paid. Added to that is the likely risk of the buyer not paying those bills.

Factoring allows the business to get money immediately. On handing over your receivables to a factor, you get paid in advance to the extent of seventy to ninety percent of the amount of receivables. The factor charges a nominal fee of two to three percent. The balances of funds are released by the factor on receiving full payment against receivables. That helps business to have improved cash flow, allowing it to make further investments, helping its growth.

Normally, the fee charged by the factor, also called discount, is proportionate to how old the receivable is. The older it is, the more is the fee. Majority of factors would not accept receivables that are more than ninety days old.

Now that we know how does factoring work, we can list its advantages. BusinessFinance.com lists the following reasons that prompt businesses to approach a factor:

It works as a means of additional working capital

It relives them from the responsibility of collecting funds from customers, especially from those who are not likely to pay in time.

  1. Businesses can book more orders.
  2. It works as a flexible funding system that increases with sales.
  3. It allows you to derive discount benefits from vendors.
  4. You can easily get finance for paying wages and taxes.
  5. You can offer credit to your bigger customers.
  6. It enables you to buy additional machinery or buildup your inventory.

Important drawbacks

The practice of factoring has drawbacks for both, the business and the factor itself.  The business owner needs to pay fee and other charges and it is not unusual that at times for these expenses to be more than the cost of availing bank loans. The factor is exposed to the risk of bad debt as a result of having got bad receivables or fraud by way of fake invoices.

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