Understanding Factoring: A Cash Flow Solution for SMEs
Many small businesses find themselves in a constant cash flow struggle due to typical invoice payment terms ranging from 30 to 90 days. This means that once an invoice is sent to the buyer, it can take weeks or even months before the funds are received by the seller. This delay can become an obstacle to a business's ability to meet essential expenses and run daily operations. This limits the growth of SMEs.
Let’s see how factoring can solve this problem
What is Factoring?
Factoring is a financial tool that can be a lifeline for small and medium-sized enterprises (SMEs) struggling with cash flow. It's a process where a business sells its invoices to a third party, known as a factoring company, at a discount. This provides immediate cash to the SME, allowing them to meet their financial obligations.
How Does Factoring Work?
- Invoice Submission: An SME submits its accounts receivables to the factoring company.
- Assessment: The factoring company evaluates the creditworthiness of the SME's customers.
- Advance Payment: Based on the assessment, the factoring company provides an advance payment, typically 70-80% of the invoice value.
- Invoice Collection: The factoring company is responsible for collecting the full amount of the invoices from the SME's customers.
- Remaining Payment: Once the invoices are collected, the factoring company remits the remaining balance to the SME, minus a factoring fee.
Benefits of Factoring for SMEs
- Improved Cash Flow: Factoring provides immediate access to cash, helping SMEs meet their financial obligations and avoid late payments.
- Reduced Credit Risk: Factoring companies often assume the credit risk associated with the SME's customers, reducing the risk of bad debts.
- Enhanced Working Capital: Factoring can free up working capital, allowing SMEs to maintain their daily operations efficiently
Types of Factoring
- Full Recourse Factoring: In this type, the SME remains responsible for the unpaid invoices if the customer defaults.
- Non-Recourse Factoring: The factoring company assumes full credit risk, and the SME is not liable for unpaid invoices.
Head to our blog to read more on “Types of Factoring”
Let’s understand Factoring with an example!
Let's say a small enterprise, called ABC Pvt Ltd, has a large order to fulfil but is facing a cash crunch. The order is worth INR 15,00,000, and the customer has agreed to pay in 60 days. ABC Pvt Ltd. needs the cash immediately to purchase raw materials, pay wages, and meet other operational expenses.
One of the advisable solutions for ABC Pvt Ltd will be Factoring
ABC Pvt Ltd can turn to a factoring company, such as CapitalXB, to get an advance payment on the INR 15,00,000 invoice. CapitalXB will assess the creditworthiness of ABC Pvt Ltd and determine that the risk of non-payment is low.
The Factoring Process:
- Invoice Submission: ABC Pvt Ltd submits the invoice of INR 15,00,000 to CapitalXB Finance Pvt Ltd
- Advance Payment: CapitalXB provides an advance payment to ABC, typically around 80% of the invoice value. So, ABC receives INR 12,00,000 immediately.
- Invoice Collection: CapitalXB will take follow up from the company for repayment
- Remaining Payment: Once the customer pays, XYZ Factoring remits the remaining INR 3,00,000 to ABC, minus a factoring fee.
Benefits for ABC:
- Immediate Cash: Acme gets the funds needed to meet its financial obligations and continue operations.
- Reduced Credit Risk: CapitalXB assumes the risk of non-payment from the customer.
- Improved Cash Flow: ABC can now manage its cash flow more effectively and avoid late payments.
- Enhanced Working Capital: INR 12,00,000 advance can be used for the business’s growth.
Summary
In essence, factoring provides a flexible and efficient way for SMEs like ABC to access cash upfront, allowing them to seize opportunities and overcome financial challenges. Factoring can be a valuable tool for SMEs facing cash flow challenges. By understanding the benefits, types, and factors to consider when choosing a factoring company, businesses can make informed decisions and leverage this financial solution to drive growth and success.
