Have you wondered how businesses that make sales on credit are able to remain in operation without running into bankruptcy? One method of financing that takes the risk attached to credit sales from these businesses is factoring.
Factoring is when a business that engages in credit sales transfers the right to collect revenue to an independent entity(separate from the business). This agent is known as a factor. The right of transfer comes with a fee attached. If a business decides to sell off its credit sales worth N100,000 to a factor, it can either be at a discounted amount or with an additional fee. Goods worth N100,000 can be sold to a factor at N90,000 or N100,000 plus an additional rate.
This acts as a medium of financing as the company can use the funds gotten from sales to factor for operational activities or profit-yielding tasks and not be stuck in the process of revenue collection. Factoring can also be referred to as account receivables financing, where account receivables represent monies yet to be received by customers who purchased your goods.
Factoring acts as a means for businesses to obtain immediate capital or funds. It transfers the burden of debt to an agent, so factoring provides risk mitigation. Also, factoring is not a loan so the sale of account receivables reduces the total amount of the company’s debt burden. It acts as a bridge that addresses short-term financing needs and supports the growth and stability of businesses.
There are certain factors to consider before a business opts for the factoring method;
Cost of factoring: Factoring involves a fee that the company would need to bear. So, businesses should carefully evaluate the costs involved and compare them to other financing alternatives.
Long-Term Implications: Factoring is a short-term financing solution and would not help a business with its long-term debt and cash flows issues. So while factoring gives businesses immediate cash for credit sales, it does not take away long-term debt that they may still incur. Long-term debt would need more structural changes that when implemented affect the payback period of “bad debts”.
To Learn
Factoring is a valuable financial tool that enables businesses to enhance their cash flow and manage credit risks effectively. By converting accounts receivable into immediate cash, companies can maintain their operations, seize growth opportunities, and reduce the burden of collecting account receivables. It is crucial for small businesses to carefully consider the costs and implications of factoring before selecting this financing method.