Factoring is a form of financing in which one company buys the receivables of another company for a fee. We show you here what types of factoring there are, how it works and what advantages and disadvantages it has.
Factoring in finance: How does it work?
Factoring is also known as receivables factoring or invoice financing. A factoring company buys the invoices or debts of another company.
The company that sells its receivables thus has the advantage that it receives payment immediately, even if the deadline for the receivable has not yet expired. Factoring can therefore be an effective means of avoiding or bridging liquidity bottlenecks.
Factoring is offered both by banks and by private companies specialising in it. Factoring services can be used by companies, self-employed persons as well as individuals.
Types of factoring
Recourse factoring is the most common form of factoring. Here, a company sells a receivable to the factoring provider. The factoring company pays the company a certain amount of the invoice immediately.
If the customer fails to pay, the company must buy back the receivable from the factoring provider - minus the amount already received. With recourse factoring, the risk of non-payment is always borne by the party selling the receivable.
In non-recourse factoring, the risk of non-payment is borne by the factoring provider. This means that a company receives part of the receivable amount immediately and the factoring company then takes care of collecting the receivable from the debtor.
With non-recourse factoring, however, it always depends on the conditions in the factoring contract. Some providers only bear the risk of non-payment if the debtor has filed for insolvency. If the debtor is not insolvent and only refuses to pay an invoice, the default risk may still lie with the selling company.
Reverse factoring is the opposite of "classic" factoring as described above. Here, it is not the seller who concludes a factoring contract, but the buyer.
This is often used by companies that want to pay their suppliers by factoring. They enter into a reverse factoring agreement and the factoring provider then pays the supplier after the supplier has shipped the goods to the buyer.
Example of factoring in finance
A company has a receivable from a customer of £2,000 and sends an invoice to the customer on 09/05/2022. The payment period is 30 days, i.e. until 08.06.2022. The company sells the receivable to a factoring company and agrees recourse factoring with it.
The fee for the factoring contract is 5% of the invoice amount. The factoring company pays £1,000 immediately. If the customer's payment is received in full by 08.06., the factoring company pays a further £900 to the selling company. The remaining £100 is the factoring fee that the selling company has to pay to the factoring company.
If the customer did not pay the invoice, the company would have to buy back the debt in full, i.e. pay back the £1,000. If a non-recourse factoring contract had been concluded and the client was insolvent, the company would still receive the £900. The risk would then be borne by the factoring company.
What does a factoring company do?
A factoring company often offers not only factoring services, but also other services such as legal advice when it comes to debt collection. That is why a factoring company works closely with lawyers.
The factoring service provider takes over tasks such as checking the financial situation of debtors and can also contact them if desired. For example, if a company does not want to deal with the debt collection process itself, it can outsource this to a factoring company that offers this service.
Drawbacks of factoring
Factoring is often only worthwhile for companies that have very large amounts of receivables, as the high fees make this service hardly worthwhile for small amounts of receivables.
Some factoring providers also require their contractual partners to sell all their receivables to them and conclude a long-term factoring contract.
Benefits of factoring
Factoring can be a good way for a company to stay liquid. For example, if it sells all its receivables to a factoring company, this can generate a high positive cash flow, allowing the company to make investments or bridge a liquidity shortage.
Some factoring providers also take over the complete receivables management for a company so that it no longer has to worry about this process at all. This can save time and personnel costs.