There are times when businesses face a slowdown in cash flow. This can be devastating, depending on the company’s financial situation. If the company has pressing financial matters to address as soon as possible, not being able to get the cash required can put the entire enterprise in jeopardy. In many cases, slow-paying customers can exacerbate, if not directly cause, such financial crisis. So, a company in such a dire situation can turn to another company by selling its accounts receivable, or its customers’ invoices. This type of financial transaction is called “factoring,” and the buyer of the accounts receivable is referred to as a “factor.”
The practice of factoring has been around for several centuries. Rules concerning factoring can be found in the Code of Hammurabi, which was created in ancient Mesopotamia in the 18th century BC. In the Western world, England began using factoring as a business tool in the 15th century AD, and the United States of America has been familiar with the practice since the Pilgrims brought it with them in the early 17th century.
In factoring, a business sells its invoices, which are generated when customers buy goods and services. The buyer, which is also known as the factor, advances most of the amount on each invoice to the seller. Usually the advance ranges from 70 to 95 percent. By buying the invoices, the factor has the legal right to collect the amount owed from the customers. The factor gives the seller the advance after the former has checked the creditworthiness of the billed customer. When the customer pays the bill, the factor gives the business the remaining balance minus its transaction (or factoring) charge. The fee is usually about 2 to 6 percent.
How Factoring Helps
In many cases, companies have to endure waiting for 30 to 60 days for payment of goods or services provided to the customer. With factoring, however, the payment process is accelerated. That’s because the company receives money within 24 to 48 hours after sending an invoice to a factor. Having an accelerated means of cash flow can be very helpful if the business has an urgent financial problem to solve. Also, factoring can be considered a better alternative to financing from traditional bank systems, since the process of providing cash is comparatively much faster. There are other advantages to consider; in addition to checking creditworthiness, factoring firms can assume the accounting operations of the company and create reports to keep clients informed of their financial situation.
Factors are specialized companies; they are often described as commercial financial enterprises. They are diverse in their respective portfolios, attending to the needs of clients from industries that include oil and gas, information technology, professional staffing, transportation, and manufacturing. New Century Financial is a prime example of a company that specializes in factoring receivables; it’s known for purchasing over $1 billion’s worth of them.
If your company mostly generates invoices with small amounts of money owed, it might not be the most economical thing to do. That’s because of the aforementioned fees that factoring firms may assess for reviewing each invoice for risk. Also, factoring should not be seen as an option in times of financial crisis. Indeed, most active users of factoring are companies in an upward cycle, and they even include Fortune 500 companies.