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Good cash flow management is crucial for the success of any business. Without it, your business will struggle to survive. This is true even if the services you offer are excellent, you have deep expertise in the industry and your business has strong growth potential. Many early-stage and growing businesses struggle to manage their cash flow. This is especially true where the revenue from the business alone is not enough to meet the demand for their services and the expenses associated with growing. If this sounds like you, you should consider obtaining external financing to inject more capital into your business. This will help your business reach its highest potential. One way to increase the cash flow in your business is through factoring. This article discusses:

  • what factoring is;
  • how it works; and
  • the advantages and disadvantages.

What is Factoring?

Factoring is a financing arrangement that allows your business to access cash immediately after invoicing your customer. A lender (called a factor) will buy a debt a customer owes to your business before that customer must pay the invoice. The factor usually pays a proportion of the invoice amount (usually around 80%) after you issue the invoice, and the factor completes its due diligence. The factor may require your customer to pay the invoice amount to a bank account controlled by the factor. Once your customer pays the total amount to that bank account, the factor will pay the remaining proportion of the invoice amount to you, minus the factor’s fees. 

Different Types of Factoring Arrangements

Factoring has existed as long as international trades have, and it has changed over the years. Today, there are many types of factoring arrangements available in the market. They are known in various names, including:

Depending on your arrangement, you may or may not be required to disclose the involvement of a factor to your customer. Traditionally, factors required the disclosure of the factoring arrangement. This is because it offers the factors better legal protection when it comes to collecting the debt. However, this has changed over the years. 

How to Recover Unpaid Invoices

Whether you’re a small business owner or the Chief Financial Officer of an ASX-listed company, one fact remains: your customers need to pay you.

This manual aims to help business owners, financial controllers and credit managers best manage and recover their debt.

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Likewise, your factoring arrangement can be with or without recourse. In a “with recourse” arrangement, you will be required to repay the proportion of the invoice amount the factor financed, should your customer not repay the debt within a prescribed time frame. On the other hand, in a “without recourse” arrangement, there is a complete sale of the debt to the factor and collecting the debt from your customer becomes the factor’s responsibility. 

Advantages and Disadvantages of Factoring

Advantages 

Disadvantages

  • Factoring gives your business access to cash as soon as the invoice is issued.
  • Factoring saves your business the time that it would need to spend collecting its debt. 
  • Factoring has a more effortless and faster approval process than traditional financing like term loans offered by banks. With the benefit of technology, many factors can complete their due diligence and provide funding within a few business days of applying. 
  • Factors charge a fee for their services. 
  • Some factors require you to enter into lock-in contracts where you become obligated to do all your factoring through that factor. Some contracts even go as far as requiring you to sell all your invoices to that factor. 
  • The law around factoring is well developed in Australia. However, it is very complex. Therefore, you will need to seek legal advice before entering into a factoring arrangement. 

Is Factoring Suitable for Your Business?

While factoring may seem like a great way to finance your business, you should consider whether factoring suits your business. It works well for a business where the business:

  • issues invoices for a fully performed contractual agreement. In addition, make sure the invoice amount is not subject to change due to any ongoing obligations to the customer or further negotiation.

For example, factoring would work well if you were selling tables for a fixed price to your customer and the invoice is issued to the customer on delivery of the tables. Here, the invoice represents a fully performed contract because you have delivered the required number of tables and the fixed price for the tables is not subject to change. Compare this to an agreement between a digital marketer and a clothing store, where the digital marketer’s fees depend on the increase in the store’s online sales and traffic to its website. Factoring is unsuitable for this arrangement because the contract price is subject to change and further negotiation during their business relationship. 

  • is growing. Factoring enables a business to readily access capital to service new clients while waiting for its existing clients to pay. This arrangement also relieves the business from frequently obtaining financing from traditional sources like banks as the business grows. 
  • has seasonal trade, and the business’s sales concentrate during a specific period of the year. The capital requirements for such businesses during the peak period are disproportionate to the capital resources of the business. Traditional lenders are generally reluctant to fund such businesses. Factoring can assist these businesses with their ongoing cash flow needs. 

Key Takeaways

Factoring arrangements can assist your business to grow. It enables you to access capital as soon as you issue an invoice. You will not need to wait for the invoice to clear. This is capital you can reinvest in your business to allow it to grow. However, you should carefully assess whether factoring is suitable for your business. Given the complex law and the prevalence of lock-in contracts in the market, you should obtain legal advice before entering into a factoring arrangement. 

If you are considering entering into a factoring arrangement and would like to have a confidential discussion with a lawyer, you should contact LegalVision’s banking and finance lawyers on 1300 544 755 or fill out the form on this page.

Frequently Asked Questions

What can factoring do for my business?

Factoring is a great way to increase cash flow for your business. This can help your business at a time of growth, especially if your revenue is not enough to cover your business’ expenses.

What should I look out for in a factoring agreement?

Make sure that you do not get stuck in a lock-in factoring contract without your knowledge. Consulting with a lawyer can help you avoid any situations where you are stuck in a contract with disadvantageous terms for your business.

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