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How Invoice Factoring Works and Why Business Owners Should Care

Many small businesses who are finally awarded a long, sought-after commercial or government contract have the dilemma of how to cash flow the new work. Especially in cases where the contract calls for work to ramp up quickly.

There are situations where a company may be billing only tens of thousands of dollars today, but hundreds of thousands of dollars within a few months. Factoring allows the potential of future payments to be used today to make payroll, pay expenses for operations.

It is in these opportunities where a factoring company can step in and provide badly needed capital to keep the ball rolling, to stay ahead of the curve when it comes to working capital for the business. Factoring is relatively simple to set up and manage, and it can allow for the oncoming growth.

The foundation of factoring is the outstanding obligation to pay by a credit worthy account debtor. When a factoring client provides a service or product to a customer under credit terms, that obligation to pay (known as an invoice) is essentially a loan from the client to their customer. The factor will be purchasing that note and collecting the assigned proceeds.

The concept behind factoring is: the creditworthiness of the customer (or account debtor) is the driver behind the decision to fund. The factor will determine a credit rating for each customer where funding is required. Factoring is completely transparent and the customer will be aware that payments should be made directly to the factor. There are 3 parts to a discount factoring transaction:

1. The Advance

This is the percentage of the face value of the invoice that is wired when the invoice is financed. Typically the advance is 80% of the invoice (i.e.; a $100,000 invoice would receive and advance of $80,000)

2. The Reserve

This amount is held back on the books when the invoice is purchased waiting for payment to be made directly to the factoring company. The reserve covers the fees associated with the financing and any credits taken from a customer that were unknown beforehand.

3. The Discount

The fee is deducted from the reserve when the invoice has been paid and the remainder of the reserve is forwarded on to the client. The discount rate is determined once at the start of the factoring relationship and is affected by the number of customers (more is better,) the credit of those customers, and the amount of funding requested.

The cost of factoring is relative to the ability to secure outside financing for your business. If used properly as a bridge to institutional bank financing it can be very effective. The factoring company is taking a higher risk than a bank and has to provide much more transactional value, meaning, the ongoing credit checks for each customer, plus tracking and collecting of invoices takes resources. Strictly speaking, factoring is not a good fit for low margin high volume business models, so invoice factoring is but one of many tools that a company has to secure capital for new contracts.

Gary Honig
Company: Creative Capital Associates Factoring Co. June 27th, 2011