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What is factoring?

Every entrepreneur should know about factoring in order to successfully use its benefits for his own business.

factoring

Being a businessperson is not as easy as you might think.

You may find your sphere of business interest, come up with a great business plan, find capital investments and even manage to launch a startup, but you still may encounter with little and big difficulties on your way to success.

One of the most widespread problems in this situation is the newly-appeared liabilities from clients and partners caused by the delayed payments for the goods or services which you provide to them.

However, you will easily eliminate this difficulty if you get to know more about factoring and how it can be applied for the development and optimization of your business.

As you can see, this topic is very interesting, especially for people who have already started their own business or have been thinking about launching a new project.

The simple definition of “factoring”


If you try to define this notion with the help of abstruse scientific terminology, you’ll come across such explanation of factoring: it’s the complex of financial services connected with the delays in the payments, which are provided to manufacturers and vendors by the bank or the expert company.

Does it seem quite difficult for understanding? Well, you can grasp the meaning of this notion better if you refer to the origin of this word.

The term “factoring” is derived from the English word “factor” and is literally translated as “a mediator”. It means that the financial operation between the vendor and the vendee is conducted by the third party.

You can ask, what is its main purpose?

Actually, factoring is a very essential factor in circulation of goods and capital in business.

Entrepreneurship has one quite typical working scheme: “You receive goods and services today, but you can pay for it in 3 days/1 week/10 days/1 month”.

These conditions are considered to be quite normal, but sometimes a customer doesn’t accomplish the terms of the agreements, delaying the payment.

The situation is not that bad if we’re talking about the short-term delay. However, if the customer (vendee) doesn’t pay for several months, it can lead to serious consequences for the vendor.

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Here’s the example what factoring in business is

“To get profit without risk, experience without danger, and reward without work, is as impossible as it is to live without being born”.
A.P. Gouthey.

Just imagine that you’ve been importing big batches of fashionable boots from the abroad. Afterwards you sell them to several big stores.

One of these stores has promised to pay you in three days, but is holding the payment up for several weeks and doesn’t fulfill the terms of agreement.

As a result, you lack money for purchasing the next batch of goods, but at the same time your other clients have already paid for their orders and they don’t want to wait until you solve your problems with the debtor, they need their goods at the moment.

What will they be doing? They will find another vendor.

And you may end up losing all your clients on the verge of financial collapse.

I’ve just described you the situation where only a factoring company can help you. It can pay you the main part of your customer’s debt in order to keep your business going.

Obviously, banks and specialized companies don’t work for free. Thus, we cannot expect enterprises to be altruistic either. You cannot disagree with me that losing a small sum of money is better than becoming a bankrupt, right?

Three parties of factoring in business


In order to grasp the notion of factoring you have to understand who participates in this process.

If we talk about casual process of purchase and sale, we can name two participants of this activity – a customer and a seller. When we talk about factoring, we have to keep in mind one more party of the purchase-and-sale process – the bank.

Thus, there are three parties of factoring operation:

  1. The factor (specialized company or factoring department of banking institution).
  2. The client of the factor (the creditor or the supplier of the goods).
  3. The debtor (the buyer of the goods).

The benefits of the factoring for every party


Practically speaking, each party of the factoring process receives its own profit:

  • Factoring company receives its interest from the completed deal. It can vary from 5 to 25%, depending on the complicacy of the deal, terms of payment and many other factors.
  • The creditor can concentrate on his/her business instead of thrashing debts from his/her debtors.

Besides, the circulation of goods and services in his/her business isn’t procrastinated during the factoring process; it’s being kept in its usual pace.

  • The profit of the debtor from this deal is minimal, because he/she will have to pay the debt anyway, the bank will surely take care of it.

The only thing that can be helpful for the debtor is the postponement of the payments, so he/she is granted more time in order to gather the necessary sum of money.

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What is factoring: how does the scheme itself work?

The scheme of factoring process is quite simple:

  1. The factor, being a mediator in this situation, grants the creditor 75-90% of the sum on account.
  2. The seller transfers the goods to the customer, specifying the terms of the delay in the payment.
  3. After a while the factor pays the creditor remaining 10-25% of the debt, deducting his/her interest for the completed deal.
  4. After a while the debtor pays off his/her debt completely.
  5. Everybody is happy, especially the creditor, whose business keeps going on successfully.

The factoring deal itself has three stages:

  • Preliminary preparation for the deal.
    The factor gathers all possible information about the creditor and conducts an interview with him/her in order to understand whether he/she is ready to become the mediator in this deal.
    Banks don’t ever participate in financially unprofitable deals.
  • Compilation of the documents.
    Obviously, the factoring company is not an unlicensed credit organization with an office in the basement. Thus, the treaty of cooperation and other necessary documents will be compiled very carefully for sure.
  • The conclusion of the deal itself and supervision over its stages.

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Types of factoring in business

Several types of factoring can be applied in practice:

  1. With further financing. In this case the creditor grants the factor the ability to receive subsequent payments from the debtor.
    Usually the factor receives 85-95% of the whole sum, while the remaining percents are being held up on the account in case of the occurrence of the claims from the debtor (customer).
  2. Without further financing. Immediately after the shipment of goods the creditor provides the bill to the factor, and he/she passes it on to the customer.
  3. Open factoring.
    Creditor warns the debtor about the participation of the factor in the deal before the conclusion of the agreement itself.
  4. Secret factoring.
    The customer doesn’t know about the presence of the factor in the deal.
  5. Without the right of regress.
    This is one of the least risky types of factoring for the seller, because the company who plays the role of the factor in the deal is obliged to pay off the customer’s debt even in case if he/she delays the payment.
  6. With the right of regress.
    Factoring company can return its client the unpaid bills if the customer is refused to pay off the debt.
    This type of factoring belongs to the “extinct” kind.
  7. Internal factoring.
    All financial operations predetermined by the deal are performed in the country of registration of the parties.
  8. International.
    The boundaries of the conclusion of the deal are not limited.

What are the perspectives of the factoring today?

Factoring has already gained huge popularity in Europe and the USA.

Domestic entrepreneurs still haven’t grasped the whole benefit from concluding the deal with the participation of the third party – the factor.

Since the last 5 years the range of services provided by the factoring companies has greatly increased. Nowadays they keep their clients’ accounts, consult them and provide clients with legal, transport and other services.

Every single entrepreneur has to know what factoring is in order to use its benefits for the development of his/her own business.

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