The common misconception is that factoring is for businesses in trouble, whereas at times that may be true, factoring can also be a tool to help a business grow. Cash flow is a common struggle for a business owner, the cost to provide a good or service to a customer of a business requires that capital be spent on raw materials, labor and other fixed overhead before receiving payment. Once the business owner invoices their customer they must now wait for payment of the goods or services, payment can often take 30 to 60 days or longer. When a business “factors” an accounts receivable (an invoice) the business owner is transferring responsibility of collecting the payment of the invoice to the factoring company thereby receiving cash now rather than waiting for their customer to make payment on that invoice. Transferring an invoice to a third party is officially known as a “factoring”. A factor or factoring company actually buys the invoice or accounts receivable from the business owner and takes on the responsibility of collecting that invoice and charges a fee for such services, this fee is called a discount rate. Traditional bank financing is less costly to a business owner however, factoring can offer the business owner the opportunity to still meet orders and increase sales when or if the bank is unwilling to extend additional credit to the business owner.
More favorable net profits through factoring:
Although factoring is more expensive than traditional bank finance it may allow a business to take advantage of sales they may otherwise have to pass on, as illustrated below:
Existing Sales W/O Factoring New Potential Sales W/ Factoring
Revenues $600,000 $1,200,000
Cost of goods sold $420,000 $840,000
Gross profit $180,000 $360,000
Fixed costs $100,000 $100,000
Factoring fees $0 $48,000
Net Profit $80,000 $212,000
Net Profit as a % 13% 18%
In this example, net profit with factoring increased both sales and net income for the business by allowing the business to take on an additional $600,000 in sales the business would have otherwise had to pass on.
Traditional bank financing can take days to weeks to finalize. However, with factoring, the payment is accelerated, since the business would receive the amount owed within 24 to 48 hours of selling the accounts to the factor.
More Attractive Financial Appearance:
Factoring functions as a payment and cash flow solution, not a loan therefore this no debt or payments of interest. As a result, factoring does not add debt to the balance sheet, it simply transfers an accounts receivable to cash with no negative impact on the balance sheet.
The more a business grows, the more strain on cash flow, factoring allows a business to handle rapid growth by providing access to capital sooner. Thus the process of factoring is conducive to growth and expansion. Although banks can extend credit to businesses, the underwriting requirements of bank loan or line may be too stringent to allow many businesses to qualify for funding.