What is Factoring?
What is Factoring. It brings to mind some bad memories from math class, but in the world of Business Finance it is the buying and selling of accounts receivable.
What is Factoring?
What is Factoring in finance? It is sometimes called accounts receivable financing. It is based on some very simple principles. If you happened to be playing cards one night and won $100 from a buddy, you might be willing to accept an IOU from him. The IOU might be payable in one month and so another buddy might offer you $80 in cash to buy the IOU from you on the spot. If you accept this deal, you have actually engaged in a something exactly the same as factoring.
Factoring is one of those kinds of deals where everyone is actually the winner. In our example, the debtor gets some time to pay his debt. You get some cash right on the spot. The person who "bought" the IOU makes a profit of $20 when the money is actually paid. In the world of business, cash flow is often very critical to the success of a business. However, it is common to bill customers and the billing cycles can run from 30 to 90 days or longer. On your balance sheet, money that is owed to the business, accounts receivable, are shown as assets, but they are assets that are worthless until the funds are actually paid.
The Factor provides the cash immediately by purchasing the accounts receivable and becoming the collection agent. Obviously, the factoring company is not interested in immediate cash flow. They have excess funds and are seeking to invest those funds. Factoring may be seen as a type of loan made to the business that owns the accounts receivable which then become the collateral for the loan.
The different types of factoring depend on who assumes the risk. In recourse factoring, if the debtor should happen to default on his obligation to pay, the factor can return or sell back the invoice to the original company. The original seller is assuming the risk. In non-recourse factoring, the factor takes the loss in case of default. Obviously, the cost of the factoring service depends on risk assumption. The recourse factoring method is much less expensive even than standard loans because the factor, unlike a Bank or other lending institution, is not assuming risk.
Two other differences in factoring terminology are notified and non-notified factoring. This simply refers to if the debtor is notified that his debt obligation has been sold to another. Factoring is very important to a many new business ventures. A new business might have cash flow issues and would want to receive payment for sales at once. However, generous payment terms are sometimes necessary to maintain a competitive position. The factoring company solves this problem for the new business by providing instant cash flow to the new business.