Ted, a hatmaker, sells hats to the Johnson company. Every month he sells around $4000 worth of hats and sends invoices accordingly. On the other hand, Johnson only pays Ted once in two months, a total of $8000 every alternate month. What if Ted is in dire need of money this month and can’t even manage a bank loan because of regulatory issues. What can he do? Here’s where factoring business companies come into play.
Ted will sell his receivable balance with John to Mike, the owner of a factoring business, at a lower price. As his monthly invoice value is $4000, he decided to sell that receivable asset to Mike for $3500 and got the payment on hand immediately. And Mike, the factoring businessman, will later receive the $4000 payment from Johnson company as Ted used to receive. This entire process of a triangular business is popularly known as business factoring. It’s kind of a risk buying and selling business.
Today, when businesses are becoming riskier every day with different financial institutions, such a transaction can mitigate the uncertainty to ease up the load from traders. In this article, we will be looking at this branch of investment opportunities in a detailed manner to get an in-depth idea of how this business work and how potential it is in today’s world.
What Is Factoring
To simply put, factoring is a business finance method where a business owner sells his accounts receivable to another agent in exchange for cash. This cash is paid immediately, and the agent is known as a factor. It’s a kind of accounts receivables financing with a different method in application.
So, in a nutshell, factoring refers to selling receivable balances to someone else. Why is this done? Well, sometimes the business owner may need some immediate money that he can’t get from the actual customer or from the bank. So selling the receivable account is a good way to get immediate money. This is an alternative option to receivable financing.
How Does Factoring Work?
Although the process sounds quite an easy one, it is actually a lengthy process. Here’s how the entire process looks like.
Step 1: A business owner will contact and negotiate with a factor to sell their accounts receivable or due invoice.
Step 2: The factor will assess the invoice amount and verify the authenticity of it.
Step 3: Upon verification and finalizing approval process, the factor agrees to pay up to 80 percent of the receivable amount. It will retain the remaining amount with them. Then the factors provide the whole payment.
Step 4: When the actual customer pays the amount in full, the factor will release the remaining retention amount after deducting their charges from the figure.
Apart from that, the customer will also need to come to a factoring agreement for this process.
Factoring Business Flow Chart
There are different types of factoring businesses (which we will be discussing shortly); no two types of factoring would share the exact same process of flow chart. But you can always draw a general process flow chart for any business, of course. So here’s a usual flow chart of the factoring business. We are considering invoice factoring in this case for a more general view.
Serve your customers > Submit sales invoice > Apply for payment against invoice to factor > Factor pays against the invoice upon verification > You collect the customer payments from factor without the reserve > Customer pays in full > Factor releases the reserve.
Types Of Factoring
Factoring business can take many forms. Depending on the business and the situation of a business owner, the factoring model can be altered or customized. Here are some of the common factoring model in current practice.
This is the most common type of factoring model. You go under an agreement with the factor that if the customer doesn’t pay the factor in full, you’re going to pay him the whole. In this way, the business works as a guarantor to the customer.
Non-recourse factoring is what is not recoursed. If the customer fails to pay or goes bankrupt, the business will not be liable to pay the debt to the factor. To simply put, the factor will bear the entire loss on their shoulder.
In this type, the customer is kept blind to a factoring contract going on between a factor and a business. It’s a discrete contract kept hidden from the customer. This is done if the business doesn’t want to disclose the information for a variety of reasons, including loss of share values.
This type of factoring doesn’t need a business to sell the Accounts Receivable. He simply accumulates the receivable amount of his business and applies for a business credit against the aggregated amount. This is also a kind of invoice finance.
The bills work more like a mortgage than an asset. So, it works pretty much like a genuine, regular debt.
Scope Of Factoring Business
In this part, we will look at different scopes of using factoring as a business solution. While there may be endless opportunities for such a model to implement, we will be discussing the 12 most common scenarios that can easily apply the factoring business method.
Accounts Receivable Factoring
This is the most widely used and applied factoring model in business. In this process, the business gathers up the Accounts Receivable invoices against one or multiple customers. Then the total invoice is sold to the factor.
The factor transfers the risk from the business to their shoulder and pays a portion of the total invoice value to the business. After the final settlement with the actual customer, the factor gets the entire payment.
Keeping the fee of their service from the remaining amount, the factor returns the due figure to the business.
As the business and the factor is dealing with invoice and Accounts Receivable balance, the method is widely known as Accounts Receivable factoring.
This type of factoring is actually dedicated to trucking or freight companies. Truck companies who have due amounts receivable from their parties for transportation transactions can factor in their unpaid invoices like any regular factoring.
You can call it the regular Accounts Receivable factoring, but with the condition that the business should be a freight business and the invoices, they get a cash receipt are against transportation costs.
The transportation factoring company will receive the bills and pay around 97% of the total value and take the risk in return. Once the customers pay the invoices in full, they will deduct a small amount as a charge and refund the remaining 3% to the trucking company.
Invoice Factoring For Freight Brokers
A freight broker deals with other people’s money in essence. Usually, a broker takes an order from a big business client to carry some goods through a third-party carrier that he has gone into contract with. Now, the carrier will carry the goods from the big client to the destination, but the payment will be received from the broker.
But the big client will not always pay the broker immediately. There may be terms of 30, 40, or even 60 days from the date of execution. So, to pay the carrier immediately, the freight broker may seek help from an invoice factoring company.
The factoring company will process the invoice of the carrier and pay the broker the required amount. Sometimes, the factor may directly pay the carrier, as well.
Government Invoice Factoring
Government invoice factoring is nothing more than just another regular factoring. The only difference is that the invoice is sold to the factor must be collected from the federal government office.
Sometimes, the government contracting agents assigns private companies and agencies to carry out some jobs on their behalf. It requires bidding on a large scale, and very few companies get selected for the offered job.
Once assigned the job, the lucky company doesn’t get paid for the initial cost they incur in carrying out the job. That’s why these companies sell the Government Contract-Paper to the factoring company and received an amount to carry out the initial expenses.
The rest of the process is similar to regular factoring.
Purchase Order Factoring
Purchase order factoring is, in reality, known as purchase order financing. If you’ve understood the governmental contract factoring, then this one is going to be pretty easy for you to grasp. It works in a similar way.
A big client places a purchase order with you. They want you to deliver a huge amount of products to them and issues formal purchase order documents. Now, you have to either arrange the products by buying from a third party or manufacture it using raw materials and labor.
To meet these expenses, you submit the purchase order to a factoring/financing company to get the money you need to manufacture or source the said products. Once the big client pays against the invoices, the factoring company will adjust its part from it.
Trucking Invoice Factoring For Trucking Companies
As discussed in the transportation factoring section, the trucking invoice factoring is simply getting payment against the invoice of trucking. The truck company submits the transportation bill they have from their clients to the factoring company.
In return, they receive the cash immediately in their bank account to pay against some obvious expense like fuel, tax, freight fee, toll charges, and many more.
Medical Bill Factoring
When companies file medical insurance claims to the medical insurance companies, it literally takes ages to get the claim settled. It’s an extremely lengthy process that very few claims are settled in a quick manner.
That’s where medical bill factoring companies come into play. You submit the medical claim documents that are accepted and are being processed by the medical insurance company to the medical factoring company.
The factor will pay you in advance against those documents and settle the transactions once the insurance company clears the payment.
Factoring In Banking
Factoring in business banking is quite not the way you look at a factoring transaction. Usually, a bank doesn’t buy any invoice you deposit to them. The bank will take the invoices you submit as mortgage and asset and offer business loans against the total invoice value.
This is more of borrowing money than factoring. But it does pay off and relieve the business owner.
Credit Card Factoring
Business credit cards factoring refers to non-merchant transactions in a merchant account. This means you allow other companies to run transactions of their business activity in your account. If you are allowing this to happen on your account, then you are the factor here.
It often occurs because companies may not generate enough sales to back up the cost they have incurred the whole period. Regulatory bodies may ask about this, and to get away with that, some companies look for a factoring company to make it look clean.
But to be honest, this is pure money laundering and an illegal act.
Small Business Factoring
Small businesses are actually a vital part of the economy of a country. For such small companies, it is often hard or beyond the possible border to go to the bank and process a loan. They often don’t have the required credibility and stability for a bank to believe in their potential.
Factoring can work tremendously well in this case. Invoice factoring, freight factoring, transport factoring, etc., can be offered to these small businesses to carry on smooth operation.
Freight Bill Factoring
Similar to the trucking company, a freight facilitator company also faces identical issues while dealing with clients. They may ship the products of their clients from one place to another, using different freight options.
But the client will pay only after they receive the goods at the final end, which may take up to 6 months in some cases. So a factoring company will buy the freight bills and documents to pay the freight company against the bills following a regular factoring process. This is also a good financing option for freight business.
Factoring Broker Training
Lastly, there is an option for any person to have come to a factoring broker. A factoring broker usually links up the businesses to potential buyers (factoring companies) who would buy their invoices to pay them.
If you want to become a factoring broker, you may take training on this specific subject, as well. Nowadays, there are many online and offline platforms that offer proper and in-depth training on how to start a factoring-brokerage and succeed in this field.
Average Cost Of Factoring Charge
There is no definitive fee for factoring. Depending on different factoring systems and methods, the factoring fees for the factoring company may vary. Usually, the factoring cost is a fee of 1% to 5% against the invoice value that the business has submitted to the factoring company.
But then again, there are variable factoring rates for the service’s diverse nature. For example, there is a variable and a flat rate.
The variable rate will increase with the time needed for the principal customer to pay against the invoice. Say, it is agreed that the factoring company will charge 2% for a 30-day termed invoice. But after 30 days, they may add 0.5% more to the initial rate for every day.
On the other hand, if you’re going for a flat rate option, there’s no such thing. The rate is flat and unchanged for as long as the actual payment is not received.
Factoring Software Solution
Running a factoring business isn’t easy. This is a type of business where you will have to deal with huge clients with multiple customers who apply for factoring help from you. To make sure you don’t miss anything, the software may play an important part here.
Similar to accounting software, factoring software like Comarch, FactorFox, Provenir, FactorView, etc., have been developed to meet the needs of the factoring business. You can easily process the factoring invoices and requisitions in a fast and easy way.
Some of these solutions do allow you to connect these data to your existing accounting or ERP software like QuickBooks and Xero.
Disadvantages Of Factoring In Business
At this point, if you think factoring is a well-organized and clever tool to use for easy immediate cash flow in the business, prepare yourself for some heavy blow! Factoring business does come with some disadvantages, as well. Here’re some of the key cons of adopting factoring for your business.
Factoring costs more than a traditional bank loan in some cases. Payment rates up to 4% against the invoice value will sometimes be more than the interest rate of a full-fledged bank loan against the same amount.
Solves Only One Problem
While business lines of credit can be used and applied to multiple channels of a business, factoring can be used in only one sector. It is even definitive, and sometimes the factoring company themselves pay the amount to the vendors you need to pay.
Issue Of Bad Debt
Although factoring companies try their level best to mitigate the issue of bad debt, it’s no wonder that some bad debts will still occur. Unfortunately, the factoring company will not take any responsibility for such bad debt, and it will come back to you for payment.
Every time you need cash advances, you have to submit related invoices and other documents to the factoring company. Again, you have to maintain a lot of documents, as well for a small amount of money.
International Factoring Association
A global body for factoring companies was founded in 1999, which is known as the International Factoring Association. The prime goal of this organization is to provide information, training, purchasing power, and share resources for the betterment of this business and the community as a whole.
How To Start A Factoring Business Company
No matter how lucrative and profitable a business may look like, it always requires blood, sweat, and tears to get going. Factoring business is no exception in this case. If you’re trying to build up your own factoring business, here are some steps you need to follow.
But before that, you need to make sure in what way you’re about to enter the market. Are you adopting this as a part-time business or a full-time one? It will be a good idea to start as a part-timer along with your other business or job, as it is a highly risky endeavor.
Steps To Start A Factoring Business
You need to have proper business plans for what you’re about to do. Make a blueprint of the steps you need to take. Contact some experts if you think your plan lacks something important.
Determining Geographic Location & Business Model
You can’t do business all over the world. So it’s always a good idea to select a niche market to start with. Choose the actual location and geographical area where you want to sell your service.
Side by side, determine the model on which you want to run your factoring business. As we have discussed earlier, there are a number of models like recourse, non-recourse, and many other methods in this business. Choose your type and go ahead.
Understanding Market Size
Measure the market size. Think deeply, if you can find enough clients for you in this market. Do you have room to play and outperform your competitors? If yes, then jump in. If not, search for a different geographical market.
Source Of Funding
You will be funding businesses, So it’s evident that you will need to gather a lot of funds from different funding options. Are you going for bank loans? Or planning to raise the business capital from the directors? Choose wisely.
Hiring Skilled Manpower
Skilled manpower is your asset. The more skillful your HR is, the better output you will get in your business. So carefully hire a competent human resource for your business.
Factoring Broker Training
If you think you or your manpower need proper and in-depth training on factoring brokerage, then you may opt for training for this purpose. There are many online and offline training options available.
Marketing For Business Development
You need to mark your place and shout to let yourself be heard. So plan on marketing and advertising your service. Devise plans on developing the business from one level to a higher one.
Use Of Software For Reporting and Growth Calculation
Purchase software to make sure you’re doing every single account with proper details. Use the software to predict your growth and aim to reach even higher with time.
With all the cons we have with the factoring business model, this is still a ray of hope for many business owners, especially the small and medium ones. It’s the only door open when the door to banks are shut down on the face due to lack of credibility.
If you think you can add value to the business, we hope this piece has been successful in enlightening you with necessary information on factoring business. Keep reading, learning, and exploring to excel and push your limits!