Financial Factoring: What it is, How it Works, Types and Advantages

Financial Factoring: What it is, How it Works, Types and Advantages

In the world of finance, there are various tools that companies can use to manage their cash flow and ensure their financial stability. One of these tools is financial factoring. In this article, we will explain what financial factoring is, what it is for, how it works, the types that exist and, in addition, we will clarify the difference between factoring and confirming.

What is financial factoring?

Financial factoring is a strategy that companies use to improve their liquidity and more effectively manage their accounts receivable. In essence, factoring involves the sale of unpaid invoices to a financial institution or factoring company. In exchange, the company receives a cash advance for the value of those invoices, allowing it to have funds immediately instead of waiting for its customers to pay on time.

This process is especially useful for businesses that are facing difficulties collecting their outstanding accounts on time, which can affect their cash flow and their ability to cover operating and financial expenses. Financial factoring provides a fast and flexible source of financing without incurring additional debt.

Suppose you are not familiar with the financial world. In that case, you may be wondering what financial factoring is, and the term may resonate in your brain like an unintelligible sound. However, since the late 1980s it has been slowly creeping into the lives of business people as an efficient aid to their business.

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Factoring has been gaining so much relevance that, in 1988. According to this organization, which currently has 19 members –both credit institutions and other commercial entities–factoring is “a short-term financing instrument, intended for all types of companies, which, in parallel with the financial service, develops other management, administration and guarantee for the insolvency of the debtors of the assigned credits.”

How a financial factoring operation works

The basic operation of factoring involves the following steps:

  • The company sells its unpaid invoices to a factoring entity.
  • The factoring entity verifies the authenticity of the invoices and the solvency of the debtors.
  • Once approved, the factoring entity advances a percentage of the value of the invoices to the company (usually around 80-90%).
  • The factoring entity is responsible for collecting invoices from the company’s clients.
  • When clients pay invoices, the factoring entity retains a commission for its services and returns the remainder to the company.

Types of financial factoring

There are several types of factoring, each adapted to the specific needs of companies. The most common types include:

Non-recourse factoring: In this case, the factoring entity assumes the risk of non-payment by the debtors. If a customer does not pay, the company is not responsible for returning the money advanced.

Factoring with recourse: In this type of factoring, the company maintains responsibility for the collection of invoices. If a client does not pay, the company must refund the advance received.

International factoring: It is used when companies have clients abroad and need financing for international invoices.

Export factoring: Similar to international factoring, but focuses exclusively on export-related invoices.

What advantages does financial factoring have?

Financial factoring offers several advantages for businesses, especially small and medium-sized businesses that may face liquidity challenges. Here are some of the main advantages:

  • Improved liquidity: Factoring provides immediate access to funds, transforming accounts receivable into cash without having to wait for typical payment terms. This allows companies to quickly have money to cover their operational needs, such as paying suppliers salaries or investing in new business opportunities.
  • Credit risk management: The factor (the entity providing the factoring) usually assumes the risk of insolvency of the debtors. This means that, in the case of non-recourse factoring, if the client does not pay the invoice, the company does not have to reimburse the factor for the advance received, thus protecting the company against the risk of non-payment.
  • Outsourcing of collections management: Factoring can include collections management, which frees the company from the administrative tasks associated with tracking and collecting payments. This allows the company to focus on its core business, saving time and resources that would otherwise be dedicated to managing accounts receivable.
  • Facilitates growth: By providing more predictable and improved cash flow, factoring allows companies to plan and execute growth strategies, such as expanding into new markets, increasing production, or investing in research and development.
  • Financial flexibility: Factoring agreements can be adapted to the specific needs of the company, with the possibility of selecting which invoices to factor and when. This offers businesses greater flexibility compared to other forms of financing that may have more rigid terms.
  • Access to financing without increasing debt: Factoring is not recorded as debt on the balance sheet since it is technically a sale of assets (accounts receivable). This helps maintain a better debt-to-equity ratio and can be an attractive option for companies that do not want to increase their debt or may not qualify for traditional loans.
  • Reducing Cash Cycle Time: By converting accounts receivable into cash quickly, businesses can reduce their cash conversion cycle, improving the overall efficiency of working capital management.

Potential for Supplier Discounts: With the cash available through factoring, a business can take advantage of discounts for prompt payments to its suppliers, thereby reducing its purchasing costs.

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