In business, limited access to capital can pose a formidable obstacle to growth, especially when your funds are tied up in unpaid customer invoices with lengthy repayment terms. Fortunately, factoring has emerged as a game-changing financial tool to help companies overcome these challenges.
Definition: What is factoring?
Factoring is an alternative financing instrument for companies. A company sells its accounts receivable (outstanding invoices) to a financial institution or factoring company, commonly known as "factor".
In return, the factor provides immediate cash to the company, enabling them to access a portion of the money trapped in unpaid invoices without waiting for customers to settle their debts. Typically, a company enters into a multi-year factoring agreement with a factoring institute, encompassing domestic and international receivables.
Unlock tied-up capital
Factoring offers a direct conversion of outstanding invoices into cash, significantly improving cash flow. It is often referred to as short-term accounts receivable financing.
Unlike traditional debt collection, the assignment of receivables to a factoring company happens immediately after invoicing. In contrast, collection agencies typically become involved only when customers are already in arrears and have received reminders.
How does factoring work?
Factoring involves three key parties:
- The company is seeking to convert its accounts receivable into cash.
- The factoring company acquires the outstanding receivables from the company and provides immediate capital.
- The customers of the company (debtor) who owe the company payments for outstanding invoices.
This is a typical factoring process – in simple terms
- Submitting the invoices: the company transfers its invoices to the factoring company.
- Invoices and debtor assessment: The factoring company verifies the legitimacy of the receivables. It also checks the debtor for creditworthiness.
- Advance payment: the factoring company advances the company a certain percentage of the outstanding invoice, usually between 80 and 90% of the total amount. In return, the factor receives interest.
- Receivables collection: the factoring company takes over the collection from the debtor. He bears sole responsibility for this in the event of non-payment.
- Settlement: Once the debtor has paid, the remaining invoice amount minus the factoring fee is disbursed to the company.
The costs of factoring
Factoring companies charge a percentage of the total invoice amount for their services, which includes receivables management, credit assessment, and assuming default risk. The compensation varies based on the scope of services provided.
In addition to this fee, there is interest on the cash advance and the liquidity provided. What does this look like in a concrete example?
Example calculation for factoring
Suppose a company has outstanding receivables totaling €500,000. In order to obtain liquid funds quickly, it assigns its receivables to a factor. The factor estimates the following costs:
As a result, €400,000 are directly available to the company. This advance payment is usually available within 24-48 hours. The company does not have to wait several weeks or months for it - and can deploy this money immediately.
Is factoring right for your company?
Factoring is a suitable financial solution for different businesses, including startups, small and medium-sized enterprises (SMEs), and freelancers. It's particularly beneficial for businesses that have already delivered their services at the time of invoicing and face challenges such as:
- A significant volume of outstanding receivables and high inventory levels.
- Long payment terms that hinder cash flow.
- An ongoing need for liquidity to fuel further growth.
- High acquisition costs for materials and machinery.
Factoring has established itself as an alternative financial instrument for companies. In 2022, the revenue of the German factoring industry was around €373 billion – an increase of 137% compared to 2012.
According to the German Factoring Association, the market penetration of factoring in this country is around ten percent. In a European comparison, however, penetration is low. For example, Belgium (18%), Spain (16%), Portugal (15.5%) or France (14%) have higher figures.
What types of factoring are there?
Factoring is highly flexible and can be tailored to a company's unique needs, goals, and business requirements. Several types of factoring are generally available:
Full Service Factoring / recourse factoring
All in one solution: With full service factoring, companies hand over all factoring processes to the factor. They sell the receivable, outsource dunning and collection, and take out 100% protection against payment defaults (del credere clause). This type of factoring is considered standard among factoring companies and financial service providers.
Companies not only receive liquidity, but also relieve their accounting system and protect themselves against payment difficulties or defaults. Full service factoring is also called recourse factoring.
In non-recourse factoring, a factor performs the same services as in full service factoring - with one exception. The factor does not bear the default risk. This remains with the company.
This is particularly suitable for companies that have an established customer base and long-term relationships with their customers. Usually, these companies are in a good position to assess the solvency of their customers.
Open factoring is characterized by transparency - especially for the company's debtors. They are instructed to transfer the outstanding receivables to the factor rather than the company.
In the past, companies were still reluctant to use open factoring. This has now changed. Factoring has become established as an alternative financing model.
However, if companies have concerns about their customer relationships, they can also use silent or non-notification factoring. In this case, the debtors are not informed that the company has assigned its receivables to a factor. The invoice shows the "regular" company as the payment recipient. The "regular" company also receives the money but transfers it directly to the factoring company.
Due date factoring
With due date factoring, the factoring company only takes over the receivables collection at the due date. The receivable is not pre-financed by the factor, which only assumes the risk of non-payment.
A company wants to sell only a part of its outstanding receivables. Then selective factoring is the way to go (also cut-out factoring). The company decides which invoices to refinance using factoring, for example, from a specific customer group (major customers with high outstanding amounts or a negative payment history).
In comparison to comprehensive full-service factoring, in-house factoring involves the company retaining control over receivables management, encompassing the dunning and collection processes. In this scenario, the factor's role is primarily limited to financing the receivables and managing default protection.
The advantages of factoring
- Improved cash flow: factoring offers companies a direct cash injection.
- Invest in growth: Improved liquidity allows the company to invest in further growth.
- Access to working capital: Factoring provides access to working capital without having to take on debt or give up equity.
- Default protection: Depending on the type of factoring, the factor assumes the payment risk, which improves the company's credit rating and creditworthiness.
- Simple receivables management: The factor can take over communication with customers and the management of accounts receivable. This saves on resources for the company.
- Fast and convenient: Factoring is usually faster and easier for a company than accessing a traditional financial instrument, such as a bank loan.
The disadvantages of factoring
- Cost: Factoring can be significantly more expensive than other financing methods because the factor charges a fee for its service.
- Limited control: once receivables are sold, the company relinquishes some of its control over collections and customer relations to the factor.
- Not suitable for everyone: Factoring is not suitable for every industry. However, it is predestined for trade, services and manufacturing.
Factoring for corporate financing
Non-bank financing methods have become increasingly crucial for companies. Factoring is such an alternative to traditional sources of financing – and has gained in importance in recent years.
Companies that rely exclusively on factoring have almost no outstanding receivables. In this way, they protect their liquidity and equity - which also makes it easier to obtain a bank loan again.
As a versatile financial instrument, factoring can seamlessly integrate into a company's accounts receivable management, offering various factoring models to choose from, each with different levels of service. This adaptability makes it a valuable resource for businesses seeking financial flexibility and growth opportunities.