Last Updated on Dec 20, 2019 by James W
Many businesses struggle with cash flow, oftentimes even when their finances otherwise seem sound. One especially common problem involves a tension between invoices due to be paid by clients in the future and a company’s current obligations.
Even when the value of those invoices is significant, a business can still lack the cash needed to keep up with its own debts and spending needs. A simple financial arrangement has been used for thousands of years to solve this common problem.
A Long History for a Specialized Type of Financing
Merchants in ancient Mesopotamia frequently found themselves facing the same recurring hurdle. They would hand goods to traveling traders who planned to sell them elsewhere over the weeks and months to follow.
In the meantime, those merchants would often need to buy more products from other traders so as to replenish their inventories. A merchant might be owed a great deal of money but not have the cash on hand to pay for these important purchases.
A special arrangement was developed to solve this common problem whereby one party would pay for the right to collect on the debts owed to the other. Encoded and described long ago in the Code of Hammurabi, this style of financing is every bit as important today.
Two Common Kinds of Invoice-Based Financing
Now most commonly known as “factoring” or “invoice financing,” this financial service has, naturally enough, evolved greatly over the years. Today, there are two general styles of factoring, each with its own advantages and drawbacks.
In the more traditional arrangement, the provider of financing, often described as the “factor,” retains the right to collect from the recipient if the debtor associated with an invoice defaults. This type of factoring can be viewed as somewhat akin to a loan where the invoice is put up as collateral, although there are important differences.
Under the other common type of factoring agreement, the recipient of financing will be released from all further obligations once the invoice has been handed over. Since this exposes the factor to more risk, the associated fees will tend to be higher than where recourse is available in the event of a debtor’s failure to pay.
Other Common Factoring Terms and Details
Beyond this basic distinction, factoring agreements commonly vary in other significant ways. Some of the issues that will often need to be accounted for by those interested in this type of financing include:
Some factors insist that businesses which seek financing from them commit to handing over all future invoices sent to particular vendors. Others, like Invoicefinancingaustralia, will not require such contracts, freeing up their clients to handle each invoice as makes the most sense at the time.
Under “no recourse” factoring arrangements, it is common for the factor to hand over the entire agreed-upon amount in exchange for the invoice. Factoring companies that retain recourse will often provide a portion of the invoice’s value immediately and then the rest, minus fees, once the debtor has settled up.
A Powerful Tool When Used Wisely
Financing an invoice will always mean accepting less than the face value because of the fees involved. Even so, many companies regularly find that it makes sense to use this type of financing responsibly so as better manage their cash flow, pursue unexpected opportunities, or for other reasons.