Factoring, accounts receivable financing, invoice financing, discounting – or whatever you want to call it – is a commonly used form of finance that provides immediate working capital to businesses. A factoring company purchases the accounts receivable, or invoices, from a company (the client). This purchase of accounts receivable typically requires the client to have sales to commercial customers (account debtors) who are credit worthy, with terms of sale usually around 30 days and less than 60 days.
Generally, these sales are for completed orders (for goods delivered or services rendered). This includes a variety of industries including, but not limited to, manufacturing, staffing, transportation and logistics, distributing, importing/exporting, medical and healthcare businesses, oil and gas, consulting, IT and technology, services, construction and many others. Some factoring companies will finance progressive or milestone billings, although this tends to be the exception more than the normal course of operation.
Once the invoices have been sold to the factor, the client receives an ‘advance’ of anywhere from 50% to 95% of the invoice, with an average advance rate more likely at 80% to 85%. Advance rates depend on the industry in which the client operates, billing practices of the client, and payment patterns of the account debtors. For example, a client in the construction industry may have offsets for subcontractor payments, retainage, and other industry related offsets. In this case, a lower advance rate may be warranted. On the other hand, staffing and transportation businesses tend to have fewer reasons for non-payment of an invoice, resulting in a higher advance rate being offered.
Assuming an 80% advance rate, the factor would then retain a 20% ‘reserve,’ which would be released back to the client once the account debtor has made payment to the factor (less the factoring or discount fees that have been earned and/or accrued). Before these payments are made to the factor, this reserve is often called an ‘accrued’ or ‘escrowed’ reserve. Once the payment has been received, however, this reserve becomes a ‘cash’ reserve, assuming full payment of the invoice (or at least the funds advanced plus fees) has been received. Factors may hold cash reserves for other potential invoices that are aging out on the factor’s books, have known disputes, or where other credit criteria may deem holding such cash reserves necessary.
Factoring can be a useful tool to companies seeking capital or needing to increase their working capital cycle. Stay tuned for more details on the inter-workings of factoring and its importance to helping companies manage their cash and their receivables while focusing on the growth of their business.
For reference, you may want to read Wikipedia, which has a good general overview of factoring including a brief history. About.com also had some other reference information on the benefits of factoring.
Happy reading. The Factor Guru.