Factoring is a unique way for businesses to receive quick cash flow to meet their immediate demands. But how does it work, and why can factoring be so valuable for fleets?
Here, we’re talking all about factoring, including what it is, how it works, and why you should consider adopting it as a way to inject cash back into your business or pay an outstanding invoice quickly.
How does factoring work?
In finance, factoring refers to a financial transaction where a business sells its accounts receivable (invoices) to a third party at a discount. That third party, called a factor, then assumes the responsibility of collecting payments from customers.
Mainly, this strategy allows your business to receive cash quickly rather than waiting for customers to pay their invoices. If there are particularly long payment terms or customers are late making their payments, it could leave you in limbo until they pay up and be especially challenging if you need funding now.
Instead of taking out a loan, factoring emerges as a way to gather cash when needed without the burden of debt or high interest rates. It can help businesses improve cash flow and manage their working capital more effectively and is commonly used by businesses with many outstanding invoices that need to cover expenses or invest in growth opportunities immediately.
But let’s break it down step by step. Here’s how the factoring process typically unfolds:
- Submission of invoices: A business submits its invoices or accounts receivable to the factor for review.
- Verification and approval: The factor verifies the invoices to ensure they are legitimate and valid, which may involve checking the creditworthiness of the business’s customers.
- Advance: Once verified, the factor advances a percentage of the total invoice value to the business. This advance rate typically ranges from 70% to 85% of the invoice value, depending on various elements such as the customer’s creditworthiness and industry.
- Payment collection: After the advance, the factor assumes the responsibility of the invoice, which means collecting payments from customers who typically pay the factor directly.
- Settlement: After the customer pays the invoice in full, the factor deducts its fees, including the discount or factoring fee, and any other applicable charges. These fees can vary between each factoring service. The remaining balance is then remitted to the business.
- Completion: The transaction is completed, and the factor provides the business with a statement detailing the transactions and settlements for each invoice.
A factoring provider will often have certain eligibility requirements that businesses must meet to qualify for their service — just like any form of financing. The good news is that factoring is generally much easier to qualify for than say, a line of credit from a financial institution.
Here are a few common criteria that a factoring agreement may require of your business:
- Businesses must have commercial or government clients. That means B2B or B2G — no “low-quality” invoices from direct consumers.
- Clients must be creditworthy. Customers (or debtors) listed on invoices must have a history of paying their invoices reliably.
- Businesses cannot have any outstanding tax liens or legal issues. Factoring companies typically prefer to work with businesses that do not have outstanding tax liens, legal judgments, or other major financial or legal problems.
- The business must have reasonable profit margins. Factoring companies may assess the profit margins of the business to ensure that there is enough room to cover the factoring fees and still generate a reasonable profit.
Keep in mind that, while these requirements and others like them are common, each factoring service is different and may have unique criteria.
Industries that can benefit the most from invoice factoring
Whether you’re a budding startup or an established enterprise, if you’re extending credit to your clients — typically within Net30 to Net60 day terms — you’re a prime candidate for invoice factoring.
Keeping in mind that factors prefer to work with B2B and B2G businesses, the following are examples of industries that commonly use factoring to their benefit.
Small and medium enterprises (SMEs)
SMEs often use factoring to improve their cash flow and address short-term financing needs. It can be particularly beneficial for smaller enterprises that face challenges in obtaining traditional financing or have limited access to credit.
Manufacturing companies
Manufacturing companies frequently have significant accounts receivable tied up in invoices. Factoring allows them to convert these receivables into immediate cash, which can be used to purchase raw materials, cover production costs, or invest in equipment for expansion.
Transportation and trucking companies
Transportation and trucking companies often face cash flow challenges due to high and recurring operating expenses such as fuel, maintenance, and payroll. Factoring helps these companies manage their cash flow by providing immediate funds based on their freight invoices.
Interestingly, transportation companies often enjoy the highest advance rates from factoring companies (90%-96% or higher), which means more cash upfront to help pay for:
- Fuel
- Maintenance and repairs
- Payroll
- Driver training
- Insurance
- Other miscellaneous expenses
Construction contractors
The nature of the construction industry often means long payment cycles and contractual terms.
Factoring provides contractors with the liquidity needed to cover common expenses such as labor, material costs, and subcontractor expenses while waiting for payment from clients.
Important elements to consider when selecting a factoring firm
Sure, an invoice factoring company may have a laundry list of eligibility requirements — but businesses should also do their due diligence when shopping around for a reliable factoring provider.
When considering factoring, make it a point to thoroughly research businesses to ensure their ethics, reliability, and suitability. Here are a few items to look out for:
Reputation and reliability
Look for a factoring company with a solid reputation and track record of reliability. Research their history, have a look at customer reviews, and consider their industry reputation to ensure they are trustworthy.
A reliable factoring service should be:
- Experienced
- Transparent
- Flexible
- Communicative
Rates and fees
Rates and fees are important here, as that’s how factoring companies make their money. When shopping around for a factor, pay close attention to their factoring rates and fee terms. Some providers may try to sneak hidden fees by you or otherwise have complex fee structures that could impact your bottom line.
Fees vary by industry, but here’s a look at typical factoring rates for each:
- Transportation: 1% – 4.0%
- Healthcare: 2.5% – 4.5%
- Staffing: 1.95% – 4.5%
- Wellness: 2.5% – 5.5%
- General small business: 1.95% – 4.5%
- Retail & wholesale: 1.95% – 4.5%
- Construction: 3.0% – 6.0%
- Food & Beverage: 2.5% – 5.5%
Curious about the difference in percentages? Here’s a quick overview of what impacts fee percentages and structures between industries:
- Risk profile: Industries with more perceived risk, such as construction, may face higher factoring rates compared to industries with lower risk, such as healthcare or government contracts.
- Average invoice size: Industries with larger invoice amounts may negotiate lower factoring rates due to economies of scale.
- Payment terms: Industries with longer payment terms, such as manufacturing or construction, may incur higher factoring rates due to the longer wait for invoice payment.
- Industry regulations: Regulatory requirements and industry-specific factors can influence factoring rates. For example, industries subject to strict regulations or seasonal fluctuations may experience higher factoring rates due to additional risk or complexity involved.
Advance rates
Consider the advance rates offered by the invoice factoring company. Higher advance rates mean you’ll receive more cash upfront, which can be beneficial for improving cash flow.
Just like factoring rates, advance rates also vary by industry and are contingent on multiple factors. Nonetheless, here are common advance rates by industry:
- Transportation: 97% – 100%
- Healthcare: 85% – 95%
- Staffing: 85% – 97%
- Wellness: 70% – 90%
- General small business: 85% – 95%
- Retail & wholesale: 80% – 95%
- Construction: 70% – 80%
- Food & Beverage: 70% – 90%
Contract terms and flexibility
Review contract terms carefully to ensure they align with your unique business requirements. Determine if terms and conditions are fair and flexible, looking for elements such as:
- Recourse vs. non-recourse factoring: Determine whether the factoring agreement is recourse or non-recourse. With recourse factoring, your business remains liable for unpaid invoices if your customers fail to pay. With non-recourse factoring, the factoring company assumes the risk of non-payment, but typically at a higher fee.
- Minimum volume commitment: Some factoring agreements may include a minimum monthly or annual volume requirement. Ensure that you can meet this requirement without over-committing your business to factoring more invoices than necessary.
- Customer notification: Determine whether the factoring company requires you to notify your customers of the factoring arrangement. Some companies prefer to handle collections directly, while others may require you to continue managing customer relationships.
Credit and collection policies
Understand the factoring company’s credit and collection policies. They should have robust credit assessment processes in place to minimize the risk of bad debt, and efficient collection procedures to ensure timely payment from your customers.
Trucking fleet cards and factoring to get you paid instantly
Factoring should be flexible and, ideally, more of a partnership than a transactional relationship.
WEX Capital is committed to transparent factoring. Tailored just for you, the WEX factoring program can help keep your business running as usual with same-day funding. And, the amount of invoices you provide is up to you! That’s true flexibility. WEX will factor in as few or as many invoices as you’d like, and representatives will even make personalized recommendations based on your unique needs.
Curious about invoice factoring with WEX? Learn more and, when you’re ready, get started.
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