Common Questions About Factoring
Invoice factoring is a form of financing that many businesses are not familiar with.
Here are some commonly asked questions about how invoice factoring works.. Visit our FAQ page to learn more about factoring with Commonwealth Capital in particular.
Factoring is the selling of invoices, or accounts receivable, to a factoring company for immediate cash. The factoring company acts as an outsourced credit department, handling the collection and processing payment on the invoices. This service helps small businesses because they don’t have to spend time managing payments, making collection calls, and figuring out which invoices have been paid and which are still outstanding.
There are some key differences between invoice factoring and a traditional bank loan:
- Factoring involves three parties (the factoring client, the client’s customer, and the factoring company) not two as in banking.
- Factoring typically provides more cash per invoice.
- Factoring typically generates cash within a day of invoicing.
- Factoring does not require covenants, unlike bank loans.
- Factoring provides additional services such as credit management and collection assistance.
- Factoring is not based on a business’s credit history, but on the creditworthiness of the factoring client’s customers.
- The amount of capital available in factoring can grow as sales grow and is not limited by a business’s equity.
Cash flow is the lifeblood of all businesses. Many businesses stumble due to cash flow issues, not because they are unprofitable. When a business uses factoring their cash flow is improved and accelerated by turning the receivables that normally sit on their books into cash. Short-term business loans, on the other hand, siphon cash out of a business. These loan programs take precious cash through a daily withdrawal from the business’s bank account, causing more harm than good.
Companies sell their receivables to a factoring company for a wide variety of reasons. Often companies are growing rapidly and become short on cash. When companies are growing quickly their free cash is usually tied up in inventory and accounts receivable. One way to solve the cash flow challenge is to factor their accounts receivable.
Sometimes, a startup or new business might factor their receivables. With limited experience and credit history, finding bank financing can be very difficult. Banks typically require 1–2 years of operating history for the business. Banks will also typically require that the business owner have a good, extended background in the industry.
Another example of a company that may use invoice factoring is a seasonal business. Some businesses may do the bulk of their sales from May and October and see virtually no business during winter months. These businesses are often not suited to a bank loan as their sales and cash flow fluctuate so much throughout the year. Banks like to see consistent earnings and cash flow to ensure that the loan is paid back. Because factoring companies use invoice-based underwriting, they are well suited to companies that have rapidly expanding sales, such as a seasonal business.
Businesses will also factor their invoices when they are in an out-of-favor industry. Like tech companies in the 1990s and real estate in the 2000s, there are usually industries that are in vogue at a given time. In the same way, banks often have industries that they will or will not lend to. Whatever the cause, if the industry is out of favor with a specific bank or banking in general, it will be very difficult to find working capital. In these times of need, factoring provides a dependable, flexible option for those businesses that are looking to stay competitive.
Finally, it is common for a business that has hit a bump in the road to use accounts receivable factoring. From losses or negative equity, to the death of a partner or even missing some payroll tax payments, a bank may call a loan due for any number of reasons. By looking at the creditworthiness of the factoring client’s customers to get repaid, factoring companies can provide working capital quickly, so the factoring client can continue growing. These are simply a few of the reasons that companies sell their receivables to a factoring company.
One of the main benefits of factoring is that it allows companies to grow their working capital as sales grow. With a bank loan, a line of credit is typically limited to the business’s equity or cash flow. By factoring, companies have a source of funding that is only limited by the growth of sales.
Factoring is also used to:
- Obtain better supplier terms by paying cash or within a discount period
- Purchase inventory
- Purchase capital equipment
- Meet payroll
- Meet other overhead
- Meet tax requirements
Because factoring is invoice-based financing, the factoring company places its emphasis on the quality of the factoring client’s invoicing documents. Businesses that factor need to have business-to-business sales. The factoring client is typically offering payment terms between 30 to 90 days, although this can vary by industry. Factoring also requires that companies sell their products on a “Final Sale” basis, not on guaranteed, consignment, or contingent sales.
Specifically, there are certain industries that factor their invoices more often than others. Some of those are:
- Temporary Staffing Companies
- Transportation / Trucking Companies
- Manufacturing Companies
- Commercial Janitorial Companies
- Security Guard Companies
- Commercial Construction Contractors
- Commercial Landscaping Companies
- Distribution Companies
- Oil and Gas Service Companies