What Is Factoring?

Factoring is a process by which a business can cash in on assets not usually recognized as assets by a traditional lender. There are several types of factoring and dozens of companies that offer the service. You need to have a basic understanding of factoring, and to consider some of the benefits and costs of factoring, before you launch into the process.

How Does Factoring Work?

Here's a brief look at how factoring works. If you have a small business, your biggest assets may not be a building, property or even equipment. In fact, your biggest asset may very well be the money owed to you by customers, or the orders you currently have. Enter factoring companies.

If you have outstanding invoices, you can "sell" those to a factoring company for a percentage of the face value of the invoice. For example, if you're set up on ninety percent factoring, you send in the invoice and the factoring company will pay you ninety percent of the face value of that invoice. But that's not typically the end of the transaction. The factoring company will send the invoice on to the customer with instructions to send payment to the factoring company. Once the customer has paid, the remainder of the money (minus the fee for factoring) will be sent to you or placed into a reserve account.

There are some variations, depending on the factoring company you choose. There are some factoring companies that charge up to seven or eight percent, but you're given the remaining ninety-two or ninety-three percent and there are no further transactions on that particular invoice.

Other companies charge a flat fee – usually a percentage of the total invoice price – but may hold some in reserve to cover the cost of invoices that never get paid. Still other factoring companies charge a variable rate depending on the length of time it takes a customer to pay.

Misconceptions About Factoring

One of the most common misconceptions about factoring is that it can be a short-term answer to cash flow problems. That's only true if the factoring company has agreed that it's going to be short term. Here's why that distinction is important.

If you enter into a factoring agreement with a particular company, you're probably going to be asked to sign a contract. Few reputable factoring agents will do any transactions without a contract. That contract will be in effect for a period of time – typically a year – and will probably include a minimum monthly fee. While most factoring agents don't enforce that fee if you hit a slow time, the fact is that the factoring company can charge that fee. If you need factoring only for one month, be sure the factoring company agrees that you can factor for only one month. The contract should expire at the end of that time so that there's no fees levied against you for months that you don't make any factoring transactions.

Finding the factoring company that meets your needs is vital. While this isn't a loan that has to be repaid, it can represent a serious financial decision that can have a great impact on your business.