Factoring is the process by which a financial institution called
a factor buys accounts receivable from a business (the client)
at a discount and takes in return an assignment of the accounts
receivable. Factoring is done with or without recourse. Factoring
with recourse means that if the factor is unable to collect from
the purchaser/debtor that the seller (the factor's client) must
repay the money advanced to it against that accounts receivable.
Factoring without recourse means that the factor accepts the
risk that the accounts receivable may be uncollectable. When
factoring is done without recourse the discount rate [the fee
charged by the factoring company] will be higher than when factoring
is done with recourse.
Depending on the terms of the factoring relationship, the company
entering into a factoring agreement may be relieved of the responsibility
(and the costs) associated with:
Generally, factoring of accounts receivable works this way:
As shipments are made, the factor's client [the seller] sends copies of the
invoices and shipping documents to the factor. The client receives cash for
the value of the invoices minus the factor's fees plus any reserves held by
the factor to offset returned goods and other deductions such as volume discounts
or cash discounts. [Under this arrangement, a creditor will typically receive
between 70% and 85% of the net invoice amount within 24 to 48 hours of shipping].
Once the invoice is paid, the creditor company will receive the remaining amount
from the factor [called the reserve] minus the factor's fee.
Aside from the obvious advantage of receiving partial payment
within a day or two of shipping merchandise, another benefit
of factoring is that creditors are able to offer credit terms
to customers they may have been unwilling to extend open account
terms to because of concerns about the buyer's creditworthiness.
Another use of factoring is as a continuing source of working
capital. Unlike a bank line of credit that has pre-established
lending limit, factoring arrangements usually have no set limits.
In addition, factors are more concerned with customers' credit
ratings than the seller's credit rating. So even if the seller
has a less than stellar credit history, a factoring company may
still be willing to purchase that company's accounts receivable.
The cost of factoring depends on a number of variables. Some
of the most important include:
The dollar volume of sales to be factored
The invoice volume
The average dollar value of factored invoices
The number of customers to be factored
Whether factoring is done with or without recourse, and
The credit worthiness of the seller's customers