What it means
Most companies that sell on credit wait 30 to 90 days to be paid, while wages, rent and suppliers will not wait at all. Factoring converts a receivable into cash almost immediately, which can keep a growing business solvent.
The factor buys the debt and usually takes on the job of chasing it. A typical arrangement advances 80% to 90% of the invoice value straight away and holds the rest back as a reserve.
When the customer settles, the factor releases that reserve after deducting its charges, which normally combine a service fee with a discount charge for the time the money was outstanding. Pricing depends on the size of your sales ledger, the credit quality of your customers and how promptly they tend to pay.
Two variants exist and the difference is not a technicality. Under recourse factoring you remain liable if your customer never pays, so the factor can reclaim the advance from you; under non-recourse factoring the factor absorbs approved bad debts and charges more for carrying that risk.
Plenty of small businesses sign recourse agreements without realising they still hold the credit risk they thought they had sold. Factoring is expensive once you annualise the cost.
A fee that reads as 2% of an invoice covers only 30 or 45 days, which can work out above 20% a year, well beyond the cost of an overdraft or a term loan. The trade off is speed and availability, because factors lend against the quality of your customers rather than the strength of your own balance sheet.
There is a relationship cost too, since in disclosed factoring your customers are told to pay the factor directly, which some read as a sign of financial strain. Invoice discounting is the confidential alternative, where you keep collecting the cash yourself and simply borrow against the value of the ledger.
In practice
Real-world examples.
Example
A recruitment agency places contractors who are paid weekly but bills clients on 60 day terms. It factors its invoices so that payroll is covered every Friday, accepting a fee of around 2% of turnover as the price of staying solvent while it grows.
Example
A haulage firm lands a contract with a large supermarket chain that insists on 90 day payment. Because the customer's credit rating is excellent, the factor offers a low fee and a 90% advance, making the deal affordable despite the long terms.
Example
A textiles wholesaler discovers its recourse agreement means it must repay a $60,000 advance after a retail customer enters administration. The finance director renegotiates onto a non-recourse facility, accepting a higher fee in exchange for the factor taking approved bad debt risk.
Think of it
“Factoring is selling your receivables for quick cash-getting money now instead of waiting for customers to pay.
Formula
Calculation
Cash advanced = invoice value x advance rate. Factoring cost = invoice value x fee rate. Approximate annualised cost = (fee / cash advanced) x number of such periods in a year.
A design agency factors a $100,000 invoice that carries 30 day payment terms. The factor advances 80%, which is $100,000 x 0.80 = $80,000 paid on the day the invoice is raised, and charges a total fee of 2.5% of the invoice value, which is $2,500.
When the customer pays in full after 30 days, the factor keeps the $2,500 and releases the remaining $17,500, because $100,000 - $80,000 - $2,500 = $17,500. The real cost is $2,500 for the use of $80,000 over 30 days, which is 3.125%, and with roughly twelve 30 day periods in a year that is an annualised cost of about 37.5%.Case study
Seen in the real world.
This is an illustrative and clearly fictional example. Ridgeway Fabrication, an invented metalwork business, won a contract that tripled its order book overnight and immediately created a cash problem, because steel had to be bought and welders paid long before any customer invoice fell due. The owner arranged a factoring facility that advanced 85% of each invoice within 24 hours.
For the first year the arrangement worked exactly as intended and Ridgeway delivered on time. The trouble came when the owner started treating the advances as ordinary income rather than borrowed money, and did not set aside the fees, which by then amounted to roughly $9,000 a month on a $450,000 ledger.
In this fictional account the fix was straightforward once the numbers were visible. Ridgeway moved its three most reliable customers off factoring and onto direct settlement with a small early payment discount, kept the facility for slower payers only, and cut its monthly financing cost by more than half without giving up the cash flow it needed.
Watch out
Common mistakes.
- Quoting the fee as a simple percentage of the invoice and forgetting that it covers only a few weeks, which badly understates the annual cost.
- Assuming that selling an invoice removes all risk, when a recourse agreement leaves the bad debt sitting with you.
- Treating the cash advance as revenue in the accounts, when the sale was already recognised when the invoice was raised.
Questions
People also ask.
Is factoring only for businesses in trouble?
No, it is common in staffing, haulage and construction where long payment terms are normal and growth eats cash faster than profit generates it.
How does factoring differ from invoice discounting?
Factoring usually means the factor collects from your customers and they know about it, while invoice discounting is confidential and you keep control of collections.
Will factoring damage relationships with customers?
It can if the factor chases aggressively, so it is worth agreeing collection procedures in writing before you sign.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%