Companies facing a cash-flow squeeze and slow-paying customers often sell their invoices or accounts receivable to specialized companies called factors. The factor advances most of the invoice amount — usually 70% to 90% — after checking out the credit-worthiness of the billed customer. When the bill is paid, the factor remits the balance, minus a transaction (or factoring) fee.
Companies that use factoring like it because they get money quickly rather than waiting the usual 30 or 60 days for payment. After sending an invoice to a factoring firm, a business can have money in its hands within 24 to 48 hours.
Some businesses use factoring to get started. Whereas banks focus on a business’s creditworthiness in considering whether to make a loan, factors look at the financial soundness of a business’s customers. As a result, firms with scant credit history may be able to sell their invoices.
But the service can be costly — several percentage points more than a conventional lender. It was once a controversial source of financing because of its ties to financially fragile companies in the garment industry. A related commonly held impression is that a company uses a factor because it isn’t credit-worthy enough to deal with a bank.
Now billions of dollars in accounts receivable flow through factors each year, many of whom specialize in particular industries such as trucking, construction or health care. Some companies use it to meet cash-flow needs as a stop-gap measure. Others prefer factoring to banks, which often require more paperwork, or other outside investors, who may want a piece of the business.
Factoring isn’t likely to be economical for a firm that sends out thousands of small-denomination invoices, because of the service fees a factor may assess for reviewing each one for risk.
Since the factoring firm handles collections, the factor customer doesn’t have to worry about billing and credit checking and about staffing those functions. Another advantage: Companies wanting to expand overseas may find factors often already have extensive experience dealing with overseas suppliers or purchasers and so using factors can make international business efforts a lot easier.