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How does factoring work and what is the true cost?

25th Oct 2016
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How does factoring work and what is the true cost?
Trade Finance Global

Factoring is a financing method or arrangement in which a business owner factors its accounts receivable at a discount to a financing party, so that the company are able to raise capital. The funder will advance a sum of money in relation to an invoice (or the promise of future income to the business). There are varying names for this type of finance and there are subtle nuances that different funders insist on. To find out more about invoice factoring, we’d recommend the Trade Finance Global Factoring guide here: https://www.tradefinanceglobal.com/invoice-finance/factoring/.

How It Works

The first hurdle that a business has in relation to factoring, is qualifying for a facility. Just like bank loans, there are standards that a company has to meet before they are considered eligible for factoring. There are 3 major points factoring companies care about. The first important element is:

Who are the company invoicing? For a business to qualify for factoring, their invoices usually have to be government or business invoices.

Consumer invoices cannot be factored, so they are not accepted.

When are the invoices payable? Only business or government invoices due in usually 30, 60, or 90 days are accepted and invoices already attached to another loan or financing arrangement are not accepted.

Lastly, what is the business status? A business must not have a history of serious legal problems or issues. Any potential difficulties or liabilities may also be looked at.

After qualifying for a factoring facility, there are a number of other steps in relation to factoring.

STEP 1: Signing The Factoring Contract

After meeting the factor’s requirements to receive financing, the factor will check the credit status and history of the clients who owe a company money. If the financier is then satisfied with the business status and terms, the company and factor will sign an agreement that sets out the terms of the factoring agreement clearly and which includes the initial payment. This will also specify the invoices or class of invoices that may be factored.

STEP 2: Notice Of Assignment

The factor will reach out to the clients of a company, and will send out a notice of assignment. This will notify the company that the borrower have assigned the invoices which relate to outstanding payments. Some factors don’t do this; if so the company will on pay the debt directly to the funder when received.

STEP 3: Get an initial payment

Once a business have completed the first and second steps in relation to a financing, the factor pays the company an initial advance which is usually 70-98% of the value of the factored invoice. The amount of the advance depends on the size of the transaction, the industry and other risk parameters. Before making an initial payment to the company, the factor will confirm the situation with the company’s client to verify the invoice.

STEP 4: Receive the Remaining Balance

Once the factor collects payment of the invoices factored from customers of the company; the company will be paid their remaining balance after the factoring company has been paid their fees. The remaining balance depends on the agreed discount rate and the factor’s fees.

What is the true cost?

The cost of factoring depends mainly on 2 factors; discount rate and length of factoring.

Discount rate

The discount rate is arrived at by looking at the values of the invoices, amongst other things. It is the cost of getting a factoring facility for a business and is usually charged weekly or monthly.

Length of Factoring

The discount rates are usually charged weekly or monthly, so the longer the length, the more a factoring company will charge.

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