Factoring is a type of business funding type whereby a business sells its accounts receivables (i.e., invoices) to a third party (called a factor) at a discount.
In advance factoring, the factor provides financing to the seller of the accounts in the form of a cash advance, often 70-85% of the purchase price of the accounts, with the balance of the purchase price being paid, net of the factor’s discount fee (commission) and other charges, upon collection from the account client. In “maturity” factoring, the factor makes no advance on the purchased accounts; rather, the purchase price is paid on or about the average maturity date of the accounts being purchased in the batch.
Today factoring’s rationale still includes the financial task of advancing funds to smaller rapidly growing firms who sell to larger more creditworthy organizations. While almost never taking possession of the goods sold, factors offer various combinations of money and supportive services when advancing funds.
Factoring is a method used by some firms to obtain venture capital. Certain companies factor accounts when the available cash balance held by the firm is insufficient to meet current obligations and accommodate its other cash needs, such as new orders or contracts; in other industries, however, such as textiles or apparel, for example, financially sound companies factor their accounts simply because this is the historic method of business funding.
The use of factoring to obtain the cash needed to accommodate a firm’s immediate cash flow needs will allow the firm to maintain a smaller ongoing cash balance. By reducing the size of its cash balances, more money is made available for investment in the firm’s growth.
Accounts receivable financing is a type of asset-financing arrangement in which a company uses its receivables — outstanding invoices or money owed by customers — as collateral in a financing agreement. The company receives an amount that is equal to a reduced value of the receivables pledged. The age of the receivables has a large effect on the amount a company will receive. In this agreement, an accounts receivables financing company, also called a factoring company, gives the original company an amount equal to a reduced value of the unpaid invoices or receivables.
This type of financing helps companies free up capital that is stuck in unpaid debts. Accounts receivable financing also transfers the default risk associated with the accounts receivables to the financing company.
Accounts receivable financing is a type of asset-financing arrangement in which a company uses its receivables as collateral in a financing agreement. Accounts receivables financing companies typically advance companies 70% to 90% of the value of their outstanding invoices. Then, the factoring company collects the debts and pays the original company the remainder of the amount collected minus a factoring fee.
How Factoring Companies Price Accounts Receivables
Factoring companies take several elements into account when determining how much to offer a company in exchange for its accounts receivables. In most cases, accounts receivables owed by large companies or corporations are more valuable than invoices owed by small companies or individuals. Similarly, new invoices are more valuable than old invoices. Generally, the easier the factoring company feels a bill is to collect, the more valuable it is, and the harder a bill is to collect, the less it is worth.
Helping Companies With Accounts Receivable Financing
This type of asset-based financing allows companies to get instant access to working capital without jumping through the hoops or dealing with the long waits associated with getting a business loan. When a business leverages its accounts receivables to boost its cash flow, it also doesn’t have to worry about repayment schedules, and instead of focusing on trying to collect bills, it can focus attention on other core aspects of its business.
In addition to providing a unique financing option for businesses, factoring companies also offer other services. These accounting-centered services include running credit checks on new clients and generating financial reports.
There are three parties directly involved: the factor who purchases the receivable, the one who sells the receivable, and the debtor who has a financial liability that requires him or her to make a payment to the owner of the invoice.
The receivable, usually associated with an invoice for work performed or goods sold, is essentially a financial asset that gives the owner of the receivable the legal right to collect money from the debtor whose financial liability directly corresponds to the receivable asset.
The seller sells the receivables at a discount to the third party, the specialized financial organization (aka the factor) to obtain cash.This process is sometimes used in manufacturing industries when the immediate need for raw material outstrips their available cash and ability to purchase on account.
Both invoice discounting and factoring are used by B2B companies to ensure they have the immediate cash flow necessary to meet their current and immediate obligations.
Invoice factoring is not a relevant financing option for retail or B2C companies because they generally do not have business or commercial clients, a necessary condition for factoring.
Negative Perceptions Associated With Factoring
Although factoring offers a number of diverse advantages, it sometimes carries negative connotations. In particular, financing through factoring companies typically costs more than financing through traditional lenders such as banks. As a result, businesses who turn to factoring companies are sometimes perceived to have poor credit or to being failing financially in other ways. However, analysts in the industry claim these misgivings are not founded on reality, and they state all manner of upwardly mobile, successful companies use accounts receivables financing as needed.
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