The process of factoring refers to selling your accounts receivable invoices to a third party. The third party then assumes obligation of collecting the invoices, taking the weight off of your shoulders. For this “service” however, the third party will charge you a respectable fee by discounting the receivables market value.
For instance, if your company sold a product for $50K to a client, and are still waiting to collect the $50K check, you may want to consider factoring. The factor will buy the invoice from you at a discounted price, perhaps for $45K, and will collect the $50K at a later date thus making $5K themselves.
The price a factor pays you depends on several things, such as the risk involved and time required until collection. However, the cash provided by these factors can be crucial to your business. If you are short on cash, opting for a factor may be a very appealing option. Likewise, if you operate in an industry with a long receivables turnover ratio, and have a substantial account receivables balance, third party factors may work wonders for your cash flows.
One of the best every day examples of third party factors is a credit card company. Although the business model is slightly different, the underlying concept is still that of a third party factor.
For example, 15 years ago you would go to the grocery store and pay your $100 grocery bill with a check. The grocery store would then hand the check over to the bank, where the bank processed the check and performed a funds transfer. The entire process could take anywhere from 3 to 7 days, if not more until the grocery store received the funds.
Today, you may pay that same bill with a credit card. The credit card company typically fronts the cash to the grocery store. Thus, the grocery store receives the money instantly, and not 7 days later. For this “service,” credit card companies charge an approximate 3% fee to the business. As a result, the grocery store only receives $97 dollars, but it has the funds right away.
Many stores don’t mind credit card payments, despite the 3% fee, because it gives them instant cash, and also avoids the problem of bounced checks. Bounced checks are basically accounts receivables that never get collected, and simply cost your business money in the long run.
Although the example above is based on credit card companies and not a traditional third party factor, the same principles still apply. Cash is king, and the option of having cash instantly at a fee-based price may be very appealing to business seeking to raise capital in the short term.