What Is Factoring and How Does It Work 

You delivered goods or rendered services, and they will pay for them in a month. It seems that your business is becoming like a bank: you lend to your customers. But unlike a bank, you don’t have free money, credit analysts, and debt collection services. And every delay in payment threatens to leave the business without working capital. Factoring will help protect you from risks and take your business to a new level.

Factoring is the exchange of future earnings for money. For example, you sold a product on a deferred or installment payment basis and issued an invoice to a customer. This invoice promises your future earnings, but you have not yet received money from the buyer. The bank, microfinance institution (MFI), or factoring company takes this invoice and pays it before your buyer does. So in the calculations between the seller and the client, there is an intermediary – a bank. It can, in addition to payment, prepare the trade documents.

Why Is Factoring Useful?  

Factoring allows you to make a profitable offer to the client  

Postponement benefits your client: by offering him comfortable payment terms, you can get ahead of your competitors. And with the help of factoring, you can release goods or provide services with a delay, without fear of cash gaps: the money comes on the day of shipment, and this money can immediately be used.

No need to leave a deposit  

Unlike a loan, factoring does not require collateral to receive the money. Instead, your receivables, that is, future earnings, become collateral.

With factoring, you can scale the turnover 

You can increase your supply during the high season or enter new markets. If the demand in the market drops, you can choose for which deliveries you need the factoring service to avoid paying extra commissions.

Factor can check the customer and control the refund  

Selling with deferred payment is always a risk. The client, who paid carefully last year, suddenly began to delay payments this year. Or a big buyer just stops answering your calls. Or a new client asks for a delay, but you are not sure he will pay for the goods. These situations are known to all businessmen.

There are factoring options that help reduce the risk of non-payment. The factor itself can check the solvency of your customers, set a limit on credit deliveries to a specific buyer and recommend the duration of a payment deferral. And after the factor provides financing, he will remind the buyer about the payment terms. Factoring can free your business from the credit routine, risk of non-payments, and cash gaps.

What Are the Disadvantages of Factoring?  

Factoring only works with deferred payment agreements  

You cannot involve a factor in cases where you enter into contracts with the condition of immediate payment. It cannot work as insurance in case of a sudden delay in payment.

Factoring only allows cashless transfers. You will not be able to pay in cash from hand to hand with a factor.  Also, for factoring, you need to collect a lot of documents

The factor will need three sets of documents:  

• for your business (the list is the same as when obtaining a loan);
• for your clients with whom the factor will work (questionnaire and balance sheets for 6–12 months);
• for the deliveries themselves (invoices, waybills, universal transfer documents).

Factor fixes payment terms. If you work through a factor, it will not be possible to informally agree with the buyer on new payment terms or return of goods – the factor will stop financing.

How Does Factoring Work?  

Step 1. You and the buyer agree to a fixed deferred payment. The client settles with you only by bank transfer. When you deliver a product or service, you have a receivable on your balance sheet (account for future payment). With this receivable and a deferral agreement, you come to the factor.

Step 2. The factor is ready to provide financing in exchange for your receivable. You conclude a factoring agreement with him and agree on how the document flow will go. From this moment, the receivables no longer belong to you, but the factor – and the client must pay the invoices issued by you according to the details of the factor. Be sure to provide these details to your buyer.

Step 3. The factor on your application transfers funding to you – the so-called first payment. The size of the first payment ranges from 70 to 99.5%, most often – 80-90% of the delivery amount. The scheme is simple: money for documents (which confirm the acceptance of the goods or the service receipt).

Step 4. Your client-buyer transfers the money he owes you to the factor account – all 100%.

Step 5. If the factor transferred only part of the funds to you during the first payment and you did not pay the commission to him, then he deducts the amount of the first payment and his commission from the money received from the client and transfers the second payment to you.