Factoring is a form of financing that is easier to obtain than a bank loan. But how does it work? Which details are important? And what are the costs? We answer these questions and more for you in this blog.
What is factoring
Factoring is financing based on invoices sent. The financing consists of an advance payment on those invoices. This runs through a current account credit between you and the factoring company.
Instead of waiting perhaps 60 days for a payment, you will receive the money in your account almost immediately. For this financing, you pay a fee for this per invoice. The percentage differs per type of factoring.
To quickly bring you home in the world of factoring, we first answer the most common questions.
Are there multiple types of factoring?
There are different types of factoring. The services, conditions, and costs vary widely. Which one is best suited for you depends on your situation. You can read more about the different types below.
To whom does my customer pay the invoice?
On the invoice, you place the payment details of the factoring company. Your customers pay to the factoring company, and your customer sees that you use factoring.
Do you remain the owner of the invoice with factoring?
This depends on the type of factoring, as you will read later.
For how long is the credit provided?
When the ownership and the risk of payment fully transfer to the factoring company, the credit (payment) is permanent. In other cases, the advance is usually temporary. This can vary per contract and country.
Who bears the risk of default?
This also depends on the type of factoring. In some cases, you transfer the invoices and the risk completely to the factoring company. While this might sound great, it can be expensive. Sometimes it’s therefore financially more interesting that you bear the risk yourself. For example, when the risk is low, and you have reserves for absorbing a default.
Who does collections?
With some types of factoring, it’s not uncommon for companies to collect invoices themselves. This is something you should pay close attention to when concluding an agreement. After all, we’re talking about your customers, and you might want to keep control over the contact.
Also remember that you are never completely “finished” with accounts receivable management. The moment there is a dispute, the factoring company will come back to you with a request to resolve it.
What is a factoring agreement?
The factoring agreement is the contract between you and the factoring company. It covers all agreements regarding the service, including the fees. There may be multiple underlying agreements for the different services.
What are the costs of factoring?
The cost of factoring depends on several factors. Think of the type of factoring, interest rates, the creditworthiness of customers and who does account receivable management. The costs range from 0.2% – 5% of the invoice value. The more aspects you transfer, the higher the costs. American Factoring is one of the most expensive forms of factoring.
Choose the right form of factoring
As we mentioned, there are different types of factoring. We zoom in on two of them:
- Traditional factoring (non-recourse and recourse)
- American (Spot) factoring
The differences are in what you finance, the services and the costs. We will not discuss other types of factoring in this article.
The most common form of factoring is traditional factoring. We can divide it into non-recourse and recourse factoring.
In the case of non-recourse, the factoring company takes care of financing of your invoices, and the risk of default. If a customer ultimately doesn’t pay, or goes bankrupt, it’s their loss and not yours.
The main difference between recourse factoring and non-recourse is that recourse doesn’t assume the risk of default. This means that the financing will lapse if it isn’t possible to collect an invoice within the agreed term. Technically, you have to repay the advance to the factoring company.
The factoring company can exclude customers from advance payment. The number of customers that a factoring company excludes is often higher in non-recourse factoring. For the same portfolio, for example, with non-recourse you will receive an advance of 75% and with recourse 90%. The percentages differ per portfolio.
With traditional factoring, it’s not uncommon to do the accounts receivable management yourself. In some countries, this is more common than in others. This is always the case for customers that are excluded by the factoring company.
Even with factoring, it remains important that you have a well organized accounts receivable.
The most flexible form of factoring is American factoring. This is also called spot factoring and is factoring per invoice. You decide which invoice you offer, and you can work with multiple factoring companies. You’re not tied to one vendor.
The great advantage of American factoring is its simplicity. You only need an invoice and the customer must be creditworthy. If you meet these conditions, you will have your money quickly. It’s also the ideal type of factoring when you only occasionally need extra financing.
American factoring offers a lot of flexibility, but it does come at a price. The costs are much higher than with traditional factoring. In most cases, it also covers accounts receivable management and the risk of default.
What is the advantage of factoring?
The main advantage of factoring is that you have access to more money. You often get a higher financing percentage than with traditional bank financing, and it is easier to arrange.
What is the disadvantage of factoring?
In general, factoring is more expensive than bank financing. Consider that your customers also have to deal with the factoring company. That can be intimidating, and there are people who see factoring as a form of weakness. And even if that’s not true, you have to take it into account.
How to choose a factoring company?
There are several things to keep in mind when selecting a factoring company. We discuss the most important aspects.
How long has it been in business?
In general, you want a factoring company that has been around for quite some time. It’s about financing your company, and that requires continuity. If the company exists less than five years, zoom in on management experience and the shareholders.
Some factoring companies require a minimum volume. This means that you are contractually obliged to sell a minimum amount of invoices. They can fine you if you don’t reach the threshold.
Financing scope of the factoring company
Not every factoring provider can finance each portfolio. When you have a high volume, you want to know upfront the level the factoring company can manage. One of the ways to check this is by requesting references.
You can request references to assess whether the company can meet the financing requirement. But not just for that. When you also transfer accounts receivable management, you want to know how the factoring company executes this. After all, it’s about the contact with your customers.
Automate the process
Even with factoring, you continue to keep certain credit management tasks. This varies from submitting invoices to the factoring company to complete accounts receivable management. So start with the basics and make sure you have set up those processes properly. Not only functionally, but also in terms of automation. Automating these workflows with credit management software saves time, prevents errors and increases effectiveness.
One final note. Factoring provides a dynamic credit. It’s based on the outstanding invoices. So one period the financing may be higher than the other.