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What is Cash Flow Factoring?

Lea Miller
Lea Miller

Cash flow factoring is the method of selling accounts receivable to a firm to secure immediate money in return for giving up a percentage of the value of the outstanding receivables. The firm offering factoring services reviews the quality of the receivables and accepts or rejects them based on the credit worthiness of the customers that owe money. Businesses can use cash flow factoring to obtain cash instead of going into debt. New businesses with little or no credit history can factor invoices because the approval is based on customer credit records rather than their own.

When a company sends an invoice to a customer for goods delivered or services rendered, the customer has an obligation to pay that invoice in a specified period of time, frequently 30 days. During that 30-day time period, or possibly longer, the company must continue funding its operations, paying expenses, and purchasing goods or raw materials. Cash flow factoring puts money back into the company's accounts without waiting for customer payment. Cash flow factoring is usually limited to invoices generated between two businesses, so sales to individual consumers would not qualify.

Businessman with a briefcase
Businessman with a briefcase

A factoring services firm typically has a skilled credit and collection staff that is experienced with the management of accounts receivable. Those skills are put to use to evaluate the outstanding accounts and determine if any of them are not suitable credit risks for factoring. After the receivables have been approved, the factoring firm notifies the customer or customers that the invoices have been factored and that it is taking over the collection process. An agreed percentage of the total receivable value will be remitted within a couple days to the business seeking cash. After the customers pay their invoices, the factoring company pays the balance of the money less a pre-negotiated fee for each outstanding amount.

If a company needs cash, it has limited options to get those funds. If it seeks a loan from a financial institution, it must sign a note promising to repay the funds and agreeing to a rate of interest to be charged. The loan will be recorded on the books as a liability. Factoring invoices, on the other hand, shifts an amount between asset accounts, from accounts receivable into cash, less the fees charged. The fees for cash flow factoring are often about the same as loan costs would be.

For new businesses that haven't had time to develop a credit history, factoring can offer an effective solution to accelerate cash flow. The company receives funds quickly and is not at the mercy of a financial institution for a loan approval. Factoring can improve the business cycle to help new companies keep producing and building their customer lists and revenues.

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