If you are new to the factoring and/or debt consolidation loans industry some of the lingo may be a bit difficult to understand. We decided to dedicate a blog post to show an example of factoring and also to define common terminology used in Factoring & Accounts Receivable Financing. Before we jump into a glossary of terms you should know a few things to have a better understanding. Factoring involves three parties; the factoring client (you), your customer, and the factoring company (us). Unlike bank loans, factoring does not require covenants nor is it based on a business;s credit history, but rather on the creditworthiness of your customers. Factoring typically generates cash within a day of invoicing and the amount of capital available can grow as sales grow.
- Account debtor: This is your client, or the person responsible for paying the invoice.
- Advance: This is the amount of money that the factoring company advances to your company when they buy the invoice. The advance is often a percentage of the gross value of the invoice and is wired shortly after the invoice is purchased.
- Advance rate: This is the amount you will receive immediately for factoring your invoices. Most factoring companies will advance between 75 and 85 percent of your invoices’ deemed value.
- Bad Debt: Bad debt is debt that has a minimal or limited chance of being collected. Bad debt is often written off or sold to a collections agency.
- Reserve: This is a portion of the value of your invoices, represented by a percentage, retained by factoring companies to potentially pay for bad expenses, payment shortages, and other issues.
- Factors: This is another name for factoring companies.
- Factoring Fee: The fee that the factoring company charges to finance your invoices. The fee is often a discount on the gross value of the invoice and is expressed as a percentage that increases over time (e.g. 1.5% per 30 days).
- Factoring period: This is the time between when the factoring company purchases your invoices and when your customers pays the invoice in full. The period typically lasts between 30 days and 90 days.
- Invoice discounting: In some countries, discounting is the same practice as factoring. However, in the U.S., discounting is another name for accounts receivable financing, which is essentially a business loan using your accounts receivable as collateral ― distinctly not factoring.
- Medical Factoring: A specialized form of factoring that is designed to work with medical companies that bill third party private insurance companies, Medicare or Medicaid.
- Notice of Assignment: A notice that is sent to customers informing them that the invoice has been factored and pledged as collateral. The NOA also informs the customer of the new payment address.
- Reserve: A specified amount of funds, often expressed as a percentage of the funding line that is used to cover bad debt expenses and payment shortages.
- Verification: The process where a factoring company verifies the validity an value of a client’s invoice with the customer.
Now let’s try an example with numbers so you can get a better understanding of a real life scenario. You are owed $10,000 from a company whose payment terms are net 60. The factoring company will immediately advance a percentage of the invoice. This particular client has decent creditworthiness so the factoring company decides to advance 90% of the invoice (10% is kept in reserve until payment is received) with a 3% factor fee.
$10,000 w/ 10% Reserve = $9,000 advanced immediately
Once the factoring company received the $10,000 from your client you will receive the different between the 10% reserve ($1,000) and 3% factor fee ($300), In this case you are paying $300 for the immediate use of $9,000.
3% Factor Fee @ $10,000 = $300 cost for immediate use of $9,000
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