Factoring is a form of trade financing for business-to-business (B2B) and business-to-government (B2G) sales transactions in which a business sells its accounts receivable (invoices) to a third party – the factoring company – at a discounted price.
The factor provides working capital to the business by advancing money against valid invoices for products sold, delivered, and accepted – or for services rendered and accepted. The business in need of cash can thus shorten its receivable cycle and accelerate its cash flow by receiving immediate cash for its invoices to customers with payment terms, instead of waiting 30, 60, or 90 days before the invoices are due for payment (or before the customers actually pay, as payment terms are not always honored)..
Over its many centuries in existence, factoring has become more and more mainstream and today is a preferred choice of many small business owners as well as larger corporations. In 2014, the factoring market in the US was estimated to be about $110 billion. Worldwide, Factoring is now a $3 trillion business!
Factoring can be a useful and sensible source of funds for new, young, and established businesses alike. However, it is not a “seed money” option for start-ups if the business does not yet have any accounts receivable to sell.
Factoring is fundamentally different from bank loans and credit lines in many aspects. Bank financing focuses primarily on the borrower’s financial strength, credit history, and available collateral for qualification, while factoring focuses mainly on the credit quality of the borrower’s debtors (i.e., the business’ customers), which makes factoring more accessible to a wider range of businesses than bank financing.
Whereas bank loans create debt and additional fixed costs for the constant periodic repayment of principal and interest, factoring is not a loan but rather a straightforward sale of assets (accounts receivable), which creates no debt and no fixed costs. Instead, factoring costs are variable costs, which are only incurred at the time when the sales revenue has already been realized.
As you sell your accounts receivable to the Factor at a slightly discounted price, think of the costs of factoring as a small reduction in revenue (similar to a 2% net 10 arrangement that most businesses would grant their customers anyway in return for accelerated payment of their invoices).
Bank loans and credit lines are also limited in size and require re-application if more money is needed later on. Factoring facilities typically grow automatically with your sales and without the need to re-apply.