By Gary Hewamadduma ACMA, CPA, CGMA, MBA, B.Sc.(Hons) in Computer Engineering

Invoice factoring (AKA; invoice discounting, debtor financing, receivables factoring) is a great option for companies that need to manage their working capital but unable to secure a conventional short-term bank loan to increase short-term liquidity.

Factoring should not be confused with “receivable financing” or short-term bank loans that merely take companies current assets (that includes Accounts Receivables) as collateral.

How does it work?

1. Company issues accurate invoices for goods and/or services provided to creditworthy customers.
2. Company sells all or portion of unpaid invoices to an invoice factoring company at a discount.
3. The factoring company does a risk assessment of the invoices (payers’ creditworthiness, payment history etc.) and funds the Company for up to an agreed upon percentage (can be as high as 90%) of the invoice value, on the same day.
4. Customers make payment directly to the factoring company as per the process in place. (As Company is no longer the rightful owner of the invoice).
5. The factoring company transfers the balance of the paid invoice (if 90% was funded in step 3 above, the 10%) minus the factoring fee.

Each factoring company may have their own process in handling any of those steps from how they measure the risk associated with invoices to the way funds are remitted. Fees may also vary. In practice, most of the factoring companies focus on single or limited number of industries so they can specialize in the risk assessment and client portfolio. (For example, a Factor who funds companies in entertainment industry may shy away from companies in bio-tech industry).

Advantages over conventional bank financing

• Company can convert its receivables into immediate operating cash.
• Infuse cash into business without additional debt in the balance sheet.
• Collection effort is transferred to the Factoring Company.
• Infuse cash only as necessary. Pay fees and interest only for the amount factored.
• Much faster than a bank loan. Most funding done within 24 hours of invoice submission.
• If it is “Non-recourse” factoring, it protects the company in the case of customer being insolvent after the funding.

However, at the beginning of the relationship, the factoring company will research the credit history of the company’s customers. Most likely, not all customers of the Company will be eligible for factoring arrangement.