Factoring is a financial service that allows businesses to sell their invoices, or accounts receivable to a third party, known as a factor, in exchange for immediate cash, which can be used to continue operations.
This service has become standard practice throughout the years because of its ability to improve cash flow, provide more accessible financing, and reduce administrative burden.
However, there are several disadvantages to factoring including the fact that factoring is essentially the practice of maintaining cash flows by paying fees to a third party and taking out debt.
WHAT IS FACTORING?
Factoring is a process by which a business sells its accounts receivable to a third party for immediate cash. The factor takes on the responsibility of collecting payments on the invoices, allowing the business to focus on other aspects of its operations.
THE DISADVANTAGES OF FACTORING
Factoring has become standard practice in the freight industry because it helps provide immediate cash flow, instead of waiting for invoices to be paid. Freight companies often have to wait weeks or even months to get paid for their services, which can create a cash flow problem.
Factoring allows a business to get immediate cash for their accounts receivable, which they can use to pay for expenses, such as fuel, maintenance, and payroll.
However, despite its short-term benefits, factoring comes along with a variety of disadvantages and risks that could potentially hurt shippers, carriers, and brokers in the long run.
The biggest disadvantage of factoring is the cost, as factors don’t provide this service for free. Instead, a business must pay a fee which is usually a percentage of the value of the invoices being factored.
The fee can vary depending on several variables, including a customer's credit history, the number of invoices being factored, and the amount of time it will take for the invoices to be paid.
LONG-TERM IMPACT ON CASH FLOW
The main reason that factoring has become so prominent in the logistics and freight industries is that it provides immediate cash flow to businesses. However, this could potentially have a negative impact on the business's cash flow in the long term.
Because factors charge a fee for their services, the business is essentially selling its accounts receivable at a discount, cutting into the long-term profits of the business.
EFFECT ON CUSTOMER RELATIONSHIPS
When a business sells its invoices to a factor, it gives control of the collection process to the factor, which then takes over the responsibility for collecting payment on the invoices. While this in and of itself may initially seem like a benefit, it could also have potentially harmful consequences when maintaining a good relationship with your customers.
Once this responsibility has been turned over to the factor, it will be in their best interest to do whatever they can to receive payment for the invoice. The debt collection practices of some factoring companies may be aggressive and could potentially harm your customer relationships.