It can be very difficult for Small and Medium Businesses (SMEs) to get traditional bank loans from risk- averse financial institutions. However, SMEs have a range of options for raising money beyond traditional financing. One such option is factoring, under which a business sells its invoices to financial institutions (the factor) at a discount for immediate cash. It is one of the best ways to improve the business's immediate term cash flow.
The Steps Involved in Factoring
- The first step is to approach Banks or Factoring Houses to obtain a Factoring Credit facility. The financial institutions will take into consideration: 1) the Borrowers’ (the SMEs’) financial strength, 2) the Borrowers’ business nature, 3) the Borrowers’ clientele and accounts receivables aging report and other support factors related to the business.
- Upon satisfaction of their due diligence, a Factoring facility will be granted by the financial institutions.
- As the first step, the SME will sell its products or services to its customers and issue an invoice, which will involve a typical sales credit terms that the SME grants to its clients.
- Second, the factor will review and approve the customer’s credit rating.
- Third, the SME will send the factor a copy of its invoices which will be verified by the factor with the customer.
- Fourth, the factor will advance 75-80% of the value of the invoices to the SME and hold 20-25% in reserve.
- Fifth, the factor will collect payments on the invoices from the customer. Finally, the factor will return the remaining 20-25% of balance to the SME, after deducting about 1-4% in fees.
There are two main types of factoring services:
Recourse Factoring: In this type, the factor requires the SME to provide a refund on any invoices that remain unpaid or are delinquent.
Nonrecourse Factoring: The factor takes on the risk of invoices that may remain unpaid, often packaging at the back end with a trade credit insurer such as Euler Hermes Due to the high risk on the factor, the rates for this type of factoring tend to be more expensive. The factor will also be more diligent in checking the creditworthiness of the SME’s client roster.
There are other subcategories of factoring depending on the specific business needs of the SME.
Advance Factoring: Under advance factoring, the factor makes an immediate payment of the entire value of the invoices.
Non-Notified Factoring: In this category of factoring, the agreement between the factor and the SME is left undisclosed to the customers and the client collects bills from the customers without letting the latter know of the factoring arrangement.
Notified Factoring: This is the reverse of Non-Notified Factoring, in this case the customers of the SME are aware of the financing arrangement with the factor. Under this type of factoring, the factor manages the customer payment schedule along with invoices and customer credit. The factor and the SME agree on a date upon which the factor will pay the SME. This method of factoring gives more control of accounts receivable to the factor.
Bulk Factoring: Under this type of factoring, the SME receives financing based on the total value of its accounts receivable based on its account receivables aging report. The SME will receive financing from the factor but maintain control of all of its operations based on accounts receivable.