Factoring sells unpaid invoices to a finance company, which advances most of the value immediately and collects from the customer.
How it runs
A percentage of the invoice is advanced up front. When the customer pays, the balance is released less a fee.
Recourse factoring leaves the business liable if the customer never pays. Non-recourse does not, and costs more.
What it is for
Bridging the gap between doing work and being paid, where that gap is long and growth is constrained by it — see working capital.
It is most common where customers are large and slow, which is typical of commercial work.
The cost
Quoted as a percentage of the invoice, which understates it. A fee of three per cent on an invoice paid in thirty days is an annual rate several times that.
Compared honestly against a line of credit, factoring is usually the more expensive option, and is used where a line is not available.
What it does not fix
A business factoring because customers pay slowly is paying to avoid the underlying problem. Terms, invoicing speed and follow-up are cheaper levers — see shortening the cash conversion cycle.
Where factoring becomes permanent rather than occasional, the business is funding its operations from a high-cost source indefinitely.
The customer relationship
The factor usually collects directly, so the customer knows. In some trades that is unremarkable; in others it signals financial difficulty.
Merchant cash advances
Sometimes offered alongside factoring, and different: a lump sum repaid as a share of daily takings. The effective rates are typically higher again, and repayment accelerates when trading is good, which is the opposite of helpful.