What is factoring? Definition, how it works and costs

Feb 4, 2022

factoring

Estimated reading time: 8 minutes

Factoring is an alternative form of financing for entrepreneurs and can be part of debtor management. Outstanding invoices are sold to a specialist company, a factoring agency, which immediately pays out most of what is owed on the invoices, regardless of the payment term. In most cases, you will have the money in the company account within 24 hours. 

In this article:

  • We describe what factoring entails
  • You get to know the advantages and disadvantages, together with points requiring attention
  • We see that there are different types of factoring
  • We consider the total cost

What is factoring?

Lengthy payment terms are often the rule rather than the exception. Larger buying companies enforce specific payment terms that, in some cases, can reach 90 days and more. 

In addition to long payment terms, invoices may simply remain open and unpaid. 

Factoring offers a solution to both of these problems in B2B commerce.

What does factoring mean? With this solution, you sell your invoices to a factoring company. The money is then often in your account within 24 hours. That means no more long waiting times. 

As a company, you therefore have immediate liquidity and capital at your disposal. Most of the risks associated with non-payment are also eliminated.

In recent years, factoring has increased significantly, partly due to stricter regulations and higher capital requirements for banks. This paved the way for alternative forms of financing such as factoring. There are now many players on the market, and various forms.

Advantages of factoring

Factoring can be a solution to many problems that companies face.

No more following up overdue invoices

If your company wants to outsource its debtor management, factoring may be the answer. The pursuit of overdue invoices will then cease. Any subsequent actions such as debt collection or legal proceedings are the responsibility of the factoring company. 

Depending on the number of invoices, it goes without saying that it will save your company time – and a few headaches! The administrative burden of following up becomes much more bearable.

Funds quickly on your account

In most cases, you never have to wait: the money goes into your business account immediately. Cash flow problems become a thing of the past, which means your company has capital available to make investments, for example.

A form of alternative financing

In this sense, factoring is also a form of alternative financing. There is no need to take on long-term debt such as bank loans or to use a credit card in the event of temporary liquidity problems.

Better risk profile

Factoring also improves your company’s risk profile. Creditworthiness can be important when making investments or entering into new contracts.

Discounts on goods

Because you can pay suppliers faster, they may provide some nice discounts.

Not taking payment deadlines into account

You no longer have to take into account debtors’ payment periods. This also means that you can grant longer payment terms to certain parties, who sometimes demand it. And this in turn could mean that you are no longer excluded from some lucrative contracts.

No currency risks

Companies that export a lot will appreciate the elimination of currency risk. The money – in foreign currency – is immediately converted by the factoring company into your currency at the rate applicable at the time, and is quickly in your account.

Disadvantages of factoring

Factoring does not only bring advantages. You must also be aware of the rules of the game and possible disadvantages.

Costs

There are costs associated. Factoring can nibble away at the profits of companies working with small profit margins.

Not all invoices are included

Some invoices are not accepted by the factoring company. The company checks the creditworthiness of each debtor. You will still have to wait for your money when it comes to certain invoices.

Look carefully at the conditions of each factoring company

Different rules apply. Some pay a very large part of the invoice immediately but reserve a residual amount until they have been able to collect the invoice themselves. For others, full payment with deduction of costs follows immediately.

A few more points of interest:

  • With factoring, your company is often tied to a long-term contract.
  • The factoring company gets to see your invoices, which may be undesirable, if this is your house bank.
  • Your customer comes into contact with the factoring company, and you have no control over how the communication is handled.
  • The agreement can sometimes apply to all invoices, including those of customers who always pay on time and with whom you never have any payment problems.

What types of factoring are there?

Meanwhile different types of factoring have emerged, often in response to market demands. 

The names and forms of these types on the market cannot be counted on one hand. They are often also marketing terms, or old wine in new bottles. Despite this, we will attempt to list a few forms:

Traditional factoring

With traditional factoring – often via a bank – your company has to outsource your entire accounts receivable management, and thus turnover, to the factoring company. You then have to hand over not only your difficult, outstanding invoices but also the invoices of prompt payers.

Usually, this type of factoring involves entering into a longer contract, which, moreover, cannot be organised as easily as 1-2-3. And it is not for every type of business: often a minimum turnover is required.

In return, a fixed amount per year or percentage of turnover is then required to be paid to the factoring company. In practice, you get paid a large percentage of the invoice, while the residual value depends on the period within which the factoring company can collect that invoice. If the payment period increases, a higher percentage is withheld.

American factoring

With American Factoring, your invoices are purchased, and a good spread of debtors is unnecessary. You can already get financing with a few debtors and thus separate invoices. So you make use of factoring when it suits you.

The conditions are also flexible: contracts can often be terminated quickly, and a minimum turnover is unnecessary.

The cost is a fixed percentage of the invoice and is determined very transparently. The advance payment you get is quite high.

Reverse factoring

This form is not used very often, and only by large companies. Unlike traditional factoring, the factoring company does not look at the financial health of your company but at the financial situation of the debtor. This provides a way for a company to improve its DSO by getting invoices paid more quickly.

Reverse factoring is an alternative for companies that do not qualify for traditional factoring. Reverse factoring can also only be applied to approved invoices.

Export factoring

This specific form applies to companies that export a lot to other countries. With export factoring they do not have to look for a factoring company in each country. Such companies often have branches in different countries.

Silent factoring

In this form of factoring, customers are not informed about the sale of their invoice to a factoring company.

On-Demand Financing

A specific form that we would like to highlight here, is On-Demand Financing.

On-Demand Financing is a form of factoring where a third party pays or pre-finances an individual invoice of your customer. That third party (or factor) will, in turn, go after your customer for the amount due. As a company you choose the invoices you want to transfer, and you can see in real time what the costs are. You are not tied to a permanent contract either.

What does factoring cost?

It is clear from the above types that a fixed cost does not exist. The factoring costs strongly depend on the party you go with for your factoring. So compare different companies and read up on the exact conditions and payment methods.

The factoring costs in any case include credit insurance, but often also other costs such as handling fees and a fixed percentage of the invoice amount. You can also take out an insolvency risk cover so that you are insured against the bankruptcy of your debtor.

How does factoring work?

Each factoring company has its own way of working, but we can distinguish the following steps:

  1. You invoice your customers.
  2. You decide which invoices you want to transfer to the factoring company.
  3. You submit those invoices to your factoring company. Often you simply have to upload the invoices to the factoring company’s portal. This can also be via a link to your software.
  4. The factoring company checks your invoices. 
  5. If the invoice meets all of the factoring company’s conditions, it will transfer a large part of the money within the agreed period. 
  6. The factoring company will handle this outstanding invoice and collect the payments.
  7. After deducting the costs, the factoring company will transfer any remaining balance to you. This step, of course, depends on the cost structure when concluding a contract with the factoring company.

Working with a factoring company

You should now be better acquainted with the pros and cons of factoring. To conclude this article, here are some questions to ask yourself when considering a factoring company:

  • Do I want it to take over debtor management in its entirety? Do I want to pass on only selected invoices, or do I want to pass on all invoices?
  • What if debtors don’t pay? Am I insured in this case?
  • What are the costs that the factoring company will charge?
  • Will I receive the money in my account immediately? What percentages are involved in direct payment?
  • Which invoices does the factoring company accept?
  • Is there a minimum number of invoices required?
  • Is there a minimum duration of cooperation?
  • Does the company accept international invoices?
  • Who bears the risk for invoices that cannot be collected?
  • Does the factoring company communicate with debtors in a professional way? What do these reminders and dunning messages look like? From which (company) name does the communication originate?

The conditions that each factoring company applies vary. Put them side by side and decide which one to go with. Good luck with the search!

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