What is factoring and its role?

Do you run a business and issue invoices with deferred payment? It is a common practice forced by the market itself. The thing is that when you complete your service or deliver goods, and payment can be made in 30, 60 or even 120 days, you can have difficulties in maintaining financial liquidity. Factoring is the answer to this challenge. See what it actually is and why it is advisable to make use of it.

Factoring – what is it?

Factoring is a service rendered by financial institutions (factors) for entrepreneurs who issue invoices with deferred payment. As part of this service, the entrepreneur provides the factor with information on payments to be made by clients, and the latter makes these payments before the deadline. When the client settles accounts arising from the invoice, the funds go to the factor’s account to compensate its costs. 

This procedure involves the following:

• the entrepreneur, also referred to as a factorer, who provides unsettled invoices to the financial institution,
• the financial institution which settles invoices for the entrepreneur before the deadline, in reality „purchasing” receivables from the company. It is called a factor;
• the business partner, also referred to as a factoring debtor, who is to make a payment for products or services.

Importantly the business partner does not necessarily need to know that the company which it cooperates with has used factoring. It all depends on the company policy and whether the company wants to inform its clients about using the solution in question. 

What are benefits of using factoring?

From the point of view of the entrepreneur, a key benefit arising from factoring is prevention of payment gridlocks – loss of budget liquidity is a critical risk, particularly if the number of invoices with deferred payment is large and clients have difficulties in fulfilling their obligations on time.

An important advantage of factoring – in case you use its full version – is elimination of problems with potential dishonest business partners. If it turns out that the client fails to settle the invoice on a timely basis, debt collection is now the duty of the factor who was assigned receivables.

How much to pay for factoring?

As you can assume, factoring entails specific expenses. The financial institution which pays invoices somehow „freezes” its means and takes over the risk. It also charges a commission for such a support – In most cases the factoring commission is ca. 10-20% of the total amount of the invoice. Still it depends on the terms of cooperation established by the factor and entrepreneur – explains an OEX E-business expert.

What kind of factoring to choose?

Factoring is an increasingly popular service, available in several variants. Aside from a non-recourse factoring which is the most expensive but guarantees full takeover of receivables, there are other types of service:

• recourse factoring – in this case the factor does not take over responsibility for business partner’s insolvency. It means as follows: if the invoice due date expires and the client fails to pay the amount, the entrepreneur who uses factoring will have to pay it;
• mixed factoring – this variant of the service involves the upper amount up to which the factor is held responsible for the business partner’s insolvency. If this limit is exceeded, it is the entrepreneur that uses the service who is held liable for unsettled invoices. 

Please remember that factoring can be open (the client is fully informed about a transfer of receivables upon the invoice issuance), or secret (the client is not informed about factoring) or half-open.

The question which variant to choose is dependent upon your business model. It is advisable to ask experts about factoring details.