What is factoring, and when is it the right choice?

Where factoring comes from

Factoring is older than the bank as you know it today. The word comes from the Latin facere, to do or to deal, and a factor was originally not a financier but a trading agent. In the transatlantic textile trade, factors sold goods on behalf of European producers, advancing money before the cargo had even been sold.

That advance turned out to be worth more than the trading role itself, and in the twentieth century the two split apart. What remained was a purely financial product: cash against outstanding invoices. In the Netherlands factoring grew above all after 2008, when banks became more cautious about working capital credit for SMEs. Business owners went looking for finance that did move with their turnover.

Which problem factoring solves

Between delivering and being paid there is a gap. Your client has 30 to 60 days to pay, sometimes longer abroad, while your own side simply carries on. Wages, suppliers and fixed costs fall due weekly or monthly. So you finance that gap yourself.

With steady turnover that is manageable. With growth it becomes a brake, and that is the part that catches business owners out. More turnover means more invoices outstanding and so more cash tied up, which makes growing cost liquidity before it earns any. Factoring takes that brake off. You submit your invoice, the financier pays out a large part straight away, and your client pays later on their own terms.

How factoring compares with other forms

Factoring is not a replacement for everything. It is one of the possible routes, and which one fits depends on where your capital is stuck.

Against bank credit

A bank facility has a fixed limit, based on your situation back then. That limit does not move with the turnover you have now. Grow fast and you hit the ceiling, and you have to renegotiate, with a fresh assessment and fresh security.

A factoring line works the other way round and scales with your invoicing, without renegotiation. Against that, you pay per invoice, where a facility carries a fixed interest cost. The full comparison is in factoring or bank credit.

Against inventory finance

The question is simple: where is your money stuck? If it sits in receivables, factoring is the logical route. If it sits in raw materials, work in progress or trading stock, then inventory finance does the same job on the other side of the balance sheet. In trading and manufacturing businesses it often sits in both places. The combination is then stronger than either one on its own.

Against a business loan

A business loan is not a working capital solution in the day-to-day sense. It is an instrument for prising a stuck situation loose. Think of restructuring existing loans, or buying out a bank that will not go further. Often that is the step that makes factoring possible at all.

The pledge, and why things often stall there

In practice this is the biggest stumbling block, and it is rarely raised up front. Banks secure themselves broadly: with a facility, receivables, stock and sometimes property are pledged together, even when the facility itself is modest.

You only notice the consequence when you want to go further. You look for alternative finance and are told your security is already tied up. The bank will not lend more and will not release the collateral either. That creates a stalemate: on paper you have a healthy receivables book, but you can do nothing with it. How that right of pledge works and what you can do about it is covered in what is a pledge.

That stalemate can be resolved. A financier can take over the existing pledge, after which the security is usable again, and usually that happens through a business loan that buys out the bank's position. It does remain precision work. Several parties are involved and the order of steps matters a great deal, so let your financier run the process rather than ending up in the middle of it.

When factoring fits

Factoring works well if you have business customers on payment terms, and if your turnover is growing or fluctuating. It suits businesses where costs run ahead of income, such as staffing, transport, construction and international trade.

When factoring fits less well

You pay per invoice, and on very thin margins those costs weigh more heavily than on a comfortable margin. So work it through before you sign.

With traditional factoring your clients can see that you use a financier. In many sectors that is normal. With a sensitive client relationship it is a trade-off you should make deliberately. If you sell mainly to consumers, or are paid on the spot, the basis for factoring falls away. There is then no payment term to bridge.

What this gives you

The key question is not whether factoring is good or bad, but where your capital is stuck and whether your security is free to use. Answer those two, and the choice between factoring, inventory finance and a business loan becomes a good deal clearer.