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Asset-based factoring occurs when a business sells off its assets to a factoring company in return for immediate payment. In most cases, the assets in question are invoices for payment from other companies that have received goods from the business without making immediate payment. The factoring company will advance a large percentage of the amount on the invoice to the business and then pay out the rest, minus a small discount fee, once it has received full payment from the debtor. By using asset-based factoring, businesses can assure steady cash flow without having to endure the credit checks that go along with applying for a business loan.
For a business, it is crucial that it finds ways to generate cash to sustain day-to-day operations. This cash can be difficult to come by, especially if it has established credit relationships with the other companies with which it does business. One way for a business to avoid the cash-flow problems associated with lengthy time spans between the delivery of goods and payment by debtors is asset-based factoring, which involves a third-party factoring company that advances cash and collects payments.
As an example of how asset-based factoring works, imagine that company A sells a product to company B for $2,000 US Dollars (USD), and company B plans to pay based on a credit arrangement with company A. Company A then contacts a factoring company, who agrees to buy the invoice and pay company A 80 percent of the amount in advance. The rest will be held in reserve by the factoring company until it can collect payment from company B. Once payment is received, the factoring company will pay the remaining amount to company A, minus a discount fee of 5 percent.
This means that company A will receive immediate payment of $1,600 USD from the factoring company. Once company B pays off the factoring company, company A will receive $300 USD more, which is the reserve amount minus the 5-percent discount fee. The factoring agency receives the discount fee, which comes to $100 USD, for its services.
How much a factoring company will advance in an asset-based factoring agreement and what the fees it charges will be are dependent on several factors. The factoring company will likely check out the credit-worthiness of the company's debtors and the volume of business the company does before establishing fees. In addition, the nature of the agreement may determine fee and advance rates. Specifically, if the business is not held responsible by the agreement for credit defaults by its debtors, the fees charged by the factoring company will be relatively high.