Factoring: Definition, Pros and Cons, Alternatives

When a business factors its accounts receivable, it effectively transfers the credit risk and collection responsibilities to the factoring company. This can be beneficial for businesses facing cash flow issues or lacking the resources to manage collections effectively. In this article, we’ll walk you through what factoring is, the pros and cons as well as alternatives to this type of financing.

What is Factoring?

Factoring is a financial transaction where a business sells its accounts receivable (outstanding invoices or customer debts) to a third party, known as a factor, at a discount. The factor provides immediate cash to the business by advancing a percentage of the total value of the accounts receivable. The factor then assumes the responsibility of collecting payments from the customers on the invoices.

It's important to note that factoring is different from a traditional loan. The transaction is based on the value of the accounts receivable, rather than the business's creditworthiness. The factor assesses the creditworthiness of the customers rather than the business itself when determining the advance rate and the discount applied.

Advantages of Factoring

First, let’s take a look at three advantages of factoring:

1. Improved Cash Flow: By converting accounts receivable into cash, factoring provides immediate cash flow. Businesses receive an advance from the factor, and don’t need to wait for their customers to pay their invoices. The money can be used to cover expenses, invest in growth opportunities, and more.

2. Time and (Some) Cost Savings: Factors assume the responsibility of collecting payments from the customer invoices, which frees up time and resources for the business. These resources can then be used for more important areas of the business, which may also result in additional cost savings.

3. No Additional Debt: Factoring transfers the ownership of the invoice to the factoring company, and therefore makes the invoice an off-balance sheet item and is not considered a liability or debt for the business anymore. The transaction is based on the value of accounts receivable, not the business's creditworthiness, which can benefit businesses with limited access to traditional financing or those that want to avoid taking on more debt.

Disadvantages of Factoring

This type of financing also has its downsides, some of which include:

1. Cost: Factoring does cost businesses money, in form of a discount or fee. Factors typically retain a percentage of the invoice amount as compensation for immediate cash and collecting payment. Factor rates vary by company and creditworthiness of the client. Factoring costs can be higher than traditional financing options like bank loans, especially when the customer has a strong credit rating.

2. Customer Perception and Relationships: The involvement of a factoring company in the collection process can be viewed as financial instability by some customers. This can potentially affect the relationship between the business and its customers. It is important to communicate the use of factors with customers to avoid any adverse impacts on the relationship.

3. Potential Long-term Commitment: When entering into an agreement with a factoring company, it may be necessary that the business is required to agree to a minimum commitment period or volume of invoices to be factored. This may make it harder to change or cancel the agreement if the business’s financial situation changes, or different needs arise. It is advised to carefully review the conditions of the agreement to understand what the long-term commitments are.

Which Businesses Should Consider Factoring?

Factoring makes sense for certain types of businesses. Brands with these characteristics might benefit from factoring:

Businesses with long payment cycles: Industries with extended payment cycles such as manufacturing or distribution can benefit from factoring. Rather than waiting on customers to pay, which can take months in some cases, businesses can receive immediate cash by factoring their invoices.

Businesses with limited collateral or credit history: Businesses that don’t have the assets to qualify for asset-based lending for example, can benefit from factoring. Factoring provides a financing option that is based on the creditworthiness of customers, rather than the business itself. This makes it accessible to businesses with limited collateral or credit history.

Businesses seeking to outsource collections: Managing the collection of accounts receivable can be time consuming and take up resources that could be used elsewhere. If businesses are looking to outsource these activities, then factoring may be a good fit for them. The factoring company then assumes responsibility for collecting payments from customers, allowing the company to focus on other areas of the business.

Alternatives to Factoring

Asset-based Loans

For businesses that have collateral such as inventory and accounts receivable to lend against, asset-based loans make for a great alternative. A business line of credit is a revolving credit facility that provides businesses with access to funds up to a predetermined limit. Businesses can draw funds as needed and repay them with interest. Lines of credit offer flexibility, allowing businesses to access funds when necessary and repay them when cash flow improves. You can learn more about asset-based loans here.

Merchant Cash Advances

Merchant cash advances are an option for businesses that have consistent credit or debit card sales. In this arrangement, the lender provides a lump sum upfront in exchange for a percentage of future card sales. Repayment is typically made by deducting a fixed percentage of daily or weekly card sales until the advance, plus fees, is repaid.

Invoice Financing

Invoice financing, also known as receivables financing, allows businesses to borrow against their outstanding invoices. Instead of selling the invoices to a third party like in factoring, businesses retain control over the collections process. Invoice financing provides immediate cash flow by advancing a percentage of the invoice value, and once the customer pays, the remaining amount is provided, minus fees or interest charges. Learn more about invoice financing here.

Crowdfunding

Crowdfunding platforms allow businesses to raise funds from a large number of individuals who contribute small amounts. This can be done through donation-based crowdfunding, reward-based crowdfunding, or equity crowdfunding, depending on the platform and the business's offerings. Crowdfunding is particularly useful for startups or businesses with innovative or socially impactful products or ideas.

It ultimately comes down to the specific needs of your business. Evaluate your cash flow needs, analyze customer payment behavior, and understand the costs and implications of factoring.

It's also important to consider the specific terms, rates, and conditions of factoring agreements and assess the costs and benefits for your particular business before engaging in factoring. If factoring is not the best solution for your business, don’t despair. There are a few alternatives to factoring, such as asset-based lending, that can help your business get the funding it needs to continue to grow.

Assembled Brands is the go-to lender for today’s top consumer goods brands. Find out more about how your business can benefit from our working capital solutions by filling out our free application.