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How Factoring Works
By Michael C. Dennis, MBA, CBF

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:

  • Checking references

  • Making credit decisions

  • Assigning credit limits

  • Collecting past due balances

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

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