HOW DOES FACTORING WORK?
Simple is good and the fewer working parts there are the less likely something can go wrong. Simple is easier to understand, figure out and fix. When it comes to financing a business, nothing is simpler than Factoring.
When a small business owner (the Seller) factors an invoice from a customer (the Debtor) it is sold to a Factor (the Buyer) who then owns the debt. The Seller replaces an Account Receivable with Cash and they are free to spend it as they wish. The Debtor on the other hand pays the Factor directly under the terms that were agreed upon.
It gets more complicated when you learn that the Factor has no greater right to payment from the Debtor than the Seller. In other words, if the Debtor does not receive or is not happy with the product or service then even the Factor will not be able to collect. It is for this reason that Factoring is riskier than most people think.
Like every form of business finance there are variations and variables to every Factoring program. In most cases a portion of the purchase amount is held back in the form of Reserve to cover nonpayment, chargebacks, and short payments. Only once an invoice is paid in full does the Factor release the Reserve. Reserves are usually 20% of the invoice and they can range from between 50% to 3%.
Good Factors lower their risk by following good credit management practices which is a benefit to both parties. They set appropriate credit limits, examine the details of every invoice along with the supporting backup and they pay close attention to all outstanding invoices. Daily reports are provided, communication is encouraged, and everyone benefits when invoices are paid timely.
A proper Factoring program creates a classic Win-Win-Win scenario. The business owner gets the cash, the customer gets the terms they want, and the Factor earns a fee and the more successful a program is the less time will be needed. Done correctly it is the definition of relationship-based financing.