Suppose you’ve sold a crate of goods to someone on credit and you’ve given your client 60 days to cover the bill. Only, you really need that money now, to cover your cost to make another crate of goods for someone else. You can turn over that customer’s debt to a financier, called a factor, who will pay you a percentage of the debt’s face value. Now you have cash in hand for the goods. Your customer owes the factor, not you. And you no longer have any financial risk associated with the transaction.
Unlike a credit card account or a bank loan, factoring doesn’t hit your balance sheet. You don’t owe anyone anything. You’re just owed less.
Nine hundred dollars in hand could be worth more to you than a thousand dollars two months from now. The factor takes that into account. “Factor rates vary from one to seven percent, depending on a lot of different variables,” said Bert Goldberg, executive director of the International Factoring Association. Some of those variables can include the credit worthiness of the debtors, the size of the account, the industry, and the time involved. Factors often charge a fee to establish a relationship with a vendor selling their accounts receivable.
“Some factors will require clients to repurchase bad debts under some circumstances,” Goldberg said. This is called recourse. Other non-recourse factors make their money by taking on the risk of collections themselves. Because of that, factors have to be very good at collecting a debt. Some factors will offer a small discount for early payment from customers with outstanding bills. But pay attention to the reputation of a factor – one bad experience with a debt collector can sour your clients on repeat business. Giving up a few percentage points on a debt may not seem like much money for the cash flow benefits, but it can really hurt a company with thin operating margins that uses the practice unwisely.