The role of factoring companies in small business financing is to speed up cash flow. Often small businesses are not paid promptly. Customers that have excellent credit, and that are certainly good for the money, might still be slow to pay their legitimate bills. Possibly they have instituted controls on their payment system that slow things down or they might be waiting until they themselves get paid.
For whatever reason, a small business may have a problem getting payment without delay, when they need the money immediately. Fortunately, a factor will often pay that small business a sizable fraction of the money owed, in a transaction called advance factoring. The money is advanced, not on the basis of the small business’s credit history or collateral, but on the basis of the worth of the invoices that show the money is owed.
The factoring company will pay a small business 70 to 90 percent of the value of its invoices, almost immediately. When the factoring company collects on the invoices, it will pay the business the rest of the money, minus a factoring fee that amounts to interest.
In addition, a factoring company will often take care of billing and credit checks. Less paperwork is involved than with a bank, as a rule, because this transaction is not a loan. The factoring company is buying the invoices, the right to collect the debt. The cash arrives quickly, possibly in two days or less when the debtor might have made the small business wait a month or two, and work to get paid.
A small business that uses a factoring company dedicates fewer hours to the business of getting paid, and more hours to its actual business. In non-recourse advance factoring, the small business gets paid for legitimate invoices, and keeps the money whether or not the factor gets paid. The small business also avoids making what amounts to an interest-free loan to a company that takes its time paying.
On the other hand, the factors’ fees amount to higher interest than a bank might charge on an actual loan. A business with a good credit history might look into getting a loan instead. Also, factors do charge fees for assessing debtors, so a business that has many small accounts to be collected may well be better off collecting each one itself.
A small businessperson may also feel that going to a factor gives the impression that his or her company has financial problems when it does not. In the past, some companies have gone to factors because they had no other option. However, a factoring company today is just one more choice for business finance, and often a good one.
To summarize, some businesses pay slowly. The approval to pay for the goods you have sent them or the services you have provided has to wind its way through an oversight chain. For some small businesses, it can be hard to wait for the money. The role of factoring companies in small business financing is to get you your money when you need it, not when your customer is finally ready to pay.