It’s important to understand that in American business finance there are two separate but similar things: factoring, and factoring loans. Factoring per se is not considered a loan, as nobody in the equation either issues nor acquires any additional debt as a result of the process.
In a ‘normal’ loan, you apply to X, where X is the funding source (be it a bank, your brother Hank, or the highly respectable Loans-R-us clerk down the street) and you ask them to loan you Y-amount of cash or credit till Z-date.
X needs to assess the likelihood of you being able to repay Y (usually with I-amount of interest added) by Z-date. If your prospects seem good enough to make you a sound investment, X lends you Y until Z, and you repay Y (with I added as interest). Deal done.
Factoring works differently.
In factoring, you apply to F, the factor, for funding based on your accounts receivables. Your what-now? Accountant-speak for the bills outstanding for work you’ve done or products you’ve sold.
The checks that are in the mail to you, but somehow haven’t managed to arrive yet by the point you have a cash flow difficulty. Essentially, your accounts receivables are monies that are fairly owed to you, but which haven’t yet arrived.
In factoring, you essentially ‘sell’ your accounts receivable invoices to your factor. They then give you a sum of money amounting to most of the amount due – they will keep a percentage as commission and a fee.
But from the moment you sell them your accounts receivables and get the funds you need, the invoices become the property of the factor.
That means you no longer have the trouble of chasing your customers for payment, because you’ve transferred ownership of their debt to your factor. That frees you up to pay whatever bills you have and go in search of your next sale.
So, factoring is not a loan because you get the money you need by selling the promises of money that should be incoming – the invoices – to your factor, and get most of the money you’re owed by your customers from your factor instead, leaving them to chase the customers for payment in due course – at which point, they keep the full sum.
That means where a bank or Hank or Loans-R-Us will be interested in your creditworthiness, because the transaction is between you and them, a factor won’t care about that.
A factor will care about your debtors’ creditworthiness, because it’s their creditworthiness will determine the likelihood that the factor will get their money back. The process of factoring is essentially a judgment of trust in the creditworthiness of your debtors.
Where you might need money right now to cover your operating costs, your factor will be more able to wait for payment, so they buy your accounts receivables and take the repayment processing off your hands, for a commission and a fee – which may well change depending on the particular factor you use.
What you get out of the deal is relatively instant cash to tide you over a cash flow crisis.
It’s also fair to say that factoring is often a more attractive option to businesses than, for instance, getting a bank loan, for those same reasons – a bank will want to understand your business’s creditworthiness, and will traditionally be fairly slow in processing the loan request and paying out the money.
Whereas because it’s your invoices that are important to a factor, not the state of your business’s creditworthiness, you can expect to get the cash you need in a much shorter time by going through a factor.
Yes, ultimately, you don’t receive the full amount of your accounts receivables in the long run – but then, your business doesn’t exist in the long run, it exists day to day.
Going through a factor, you can keep the lights on and the computers working today, while taking probably a small hit on your income from accounts receivables overall.
So ultimately, no, factoring in and of itself is not classed as a loan because you don’t directly repay the factor for the money they give you.
That’s not a loan, but a sale of the right to the future income from your sales receivable. You exchange the invoices for work done or goods sold for the cash from the factor.
What sometimes confuses people is that you can also get a factoring loan, where the invoices remain your property and you pay the factor back for the cash they advance you, using your accounts receivable as collateral for the loan.
But that’s a different thing from the relatively straightforward business of factoring. as the parties neither issue nor acquire debt as part of the transaction. The funds provided to the company in exchange for the accounts receivable are also not subject to any restrictions regarding use.
What is a factoring loan?
In standard factoring, you simply ‘sell’ your accounts receivables – the honestly presented invoices for work done or goods sold that have yet to be paid by your customers or clients – to a factor, who then gives you a large percentage of the amount due and takes control of chasing the payments from your customers.
In a factoring loan, the invoices remain your property, but you use them as collateral to get a cash flow loan from a factor.
Whereas in a standard loan, you borrow money from a lender and use material assets as collateral (like your house, for instance), in a factoring loan, you present the invoices to the factor as a way of showing that you will be good for the loan you’re asking for.
The factor will usually grant the loan (often minus a commission and a lending fee), but will not simply buy the invoices from you. The invoices remain your property, and you also retain the responsibility for ensuring the invoices are paid by a given date.
If they are, you then repay the factor the full amount of the accounts receivable, rather than just the full amount you were loaned.
That means the factor makes a small percentage profit by way of the commission and fees, and you get relatively immediate cash to see you over a shortfall, without ever selling or resigning the invoices into the factor’s hands for them to chase.
This is a useful form of loan for many businesses, especially those who offer notional payment terms. For instance, if you offer payment terms of 30 days, if your customers pay on receipt of the invoice, you probably have enough cash flow to keep the lights on past Day 15.
If, on the other hand, your customers take full advantage of the 30 days, you might find yourself in a cash flow shortfall on Day 15.
It would break the terms on which you allowed your customers to pay if you were to demand immediate payment on Day 15, simply because you had a need for the money to pay your own creditors, like the power company.
But on the other hand, you might not want to engage in full-on traditional factoring, because you might want to keep control of the relationship with your customer or client.
That’s especially likely if you want to do future business with them, because the sudden shift from you requesting payment to a third-party factor requesting - or indeed, demanding – payment might sour an otherwise advantageous ongoing relationship.
In those circumstances, a factoring loan can help businesses bridge the gap between customers who are likely to pay eventually and within an agreed timescale, and the ongoing cash flow needs of your company.
After all, holding on to as-yet-unpaid invoices while you cannot meet the demands of your own creditors is not only a dubious business decision, it’s personally frustrating too, because the sense that you have the money to pay your creditors, but that it’s all tied up in invoices, is pretty exasperating.
A factoring loan helps you unlock the potential cash flow that’s trapped in your accounts receivables, without either handing over the payment processing to a third-party factor or alerting your bank and having to wait on their decision simply to keep the cash flow rolling through your business.
As with true factoring, a factoring loan is also attractive to many business owners because it allows you to get hold of the cash you need relatively quickly compared to a bank.
They’re also not concerned with the creditworthiness of your business, but with the likely creditworthiness of your customers, because it’s that likelihood that your customers will pay that determines your ability to repay your factoring loan.
The time and cashflow a factoring loan buys you also lets you search for your next customers, and either amass some backup cashflow, or if nothing else, lets you amass some new accounts receivable to keep your business afloat, alive, viable and moving forward.