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Factoring companies provide capital to businesses through a transaction known as “Receivable Purchase Financing" and sometimes may also provide "Purchase Order Financing". These companies offer an alternative to bank financing or traditional loans. Factored finances are provided by a company that specializes in a practice known as “invoice factoring.” In this type of financing, a “factor” is the company that provides the finances to a company in need of the funds. With this type of transaction, the business seeking funds sells their accounts receivables, or invoices” to a factor at a discounted rate. A factor is a third party company that provides funds to the business for their discounted invoices.
Advance vs. Maturity Factoring
Basically, there are two types of factor financing: Advance factoring and Maturity factoring. With the advance factoring model, the factor generally pays the business between 70 to 85 percent of the full value of the invoices. In turn, the business receives necessary cash to continue to conduct business. The factor collects on the invoices for full payment of the funds provided to the business. With the maturity model, invoices are sold to the factor, just as with the advance model. However, funds are provided to the business when the “invoice maturity” is achieved and the factor is able to collect on the invoice. Once the invoice has matured, the factor collects the funds and then provides the funds to the business in need of cash.
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Factoring vs. Bank Loans
Factoring differs from bank loans in several ways. Banks provide loans based on a business' credit rating and ability to pay back the loan. A bank loan is evaluated based on the financial condition of the company, inventory, accounts receivables and many other factors. Banks provide loans in a lump sum and assess an additional charge for interest. Interest is determined by a calculated interest rate. A business that has a less than perfect credit history may receive a bank loan with a higher interest rate than a business that has an excellent credit history.
The bank generally considers the business' total assets as the most important basis for approving or denying a loan. The bank will consider the real property of the business, the worth of the equipment owned by the business, as well as business inventory to underwrite a loan. The bank will often examine the business far beyond its credit history to determine whether or not to approve the loan. Factoring, on the other hand, is not a loan. Factoring is a purchase of the business' financial assets. Factoring is the actual sale of a portion of the business' receivables.
Factoring is based on the immediately-available invoices on which the business may collect payment. This model assumes that the business has already provided the goods and/or services to the customer and is now owed money for the goods and/or services. The factor essentially steps in and provides funds either prior to collection of the payment from customers or upon payment by the customers, depending on whether the terms are defined as advance or maturity factoring.
The amount of a bank loan is generally determined by the borrower. The borrowing business will determine that the business requires a certain amount to continue to conduct business, purchase materials or any number of needs. The borrowing company completes an application for a loan for the amount they determine with the bank of their choice. The loan is either funded or rejected based on the decision of the bank. Because the bank considers the total assets of the business, the business may not qualify due for several reasons.
On the other hand, with factoring the amount of the funds is entirely determined by the value of the receivables. The total assets of the business are not considered with factor financing. Only the amounts of invoices are considered in the funding process. This is one reason factoring is often called “receivable purchase financing.” The financing amount is based on the amount of the net amount invoiced to clients.
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Factoring Companies Instead of Traditional Finance Companies or Banks
A factoring company offers business financing as an alternative to traditional business financing. For business that do not qualify for or do not want a bank loan, a factor financing may be an attractive alternative. The factoring company collects the outstanding funds due the business as defined by the transaction. Essentially, the factor assumes the risk of collecting the funds for the receivables.
Because factoring is not a loan, the conditions of the transaction do not include consideration of the business' total assets. With the advance factoring model, the business is provided with a cash advance for all or a portion of the business' invoices. The factoring company collects on the invoices to recover the funds. This transaction is beneficial for a business in need of funds, as well as for the factoring company. Because invoices are sold to the factoring company at a discount, the factor is able to recover a the difference between the discounted price paid for the invoice and the full invoice amount. This differential is often referred to as the “discount fee.” The factoring company is compensated through the commission model instead of charging interest, as with a bank loan.
When seeking an alternative to a bank or finance company loan or a credit line, factoring provides a viable alternative for obtaining funds to apply back to the business. The amount of funds provided to the business is entirely determined by the company's receivables. The business need not be concerned about a high interest rate or losing collateral if they are not able to make payments on a loan. Risk to the business is reduced with a factoring transaction. Instead of looking to a bank or finance company for a business loan, consider the possibility of a factoring arrangement to obtain the necessary funds for the business. With reduced risk and no interest charges to your business, your business remains safe while you secure the capital you need.
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