Factoring is a word often misused synonymously with accounts receivable financing.
Accounts receivable financing is a line of credit secured by your receivables. When you ship, you borrow the receivable amount and when the receivable is collected, you pay down the line of credit. You pay interest on the outstanding balance on your line of credit, plus usually a service fee.
The factoring of accounts receivable is a sale of those receivables to a third party. The third party buyer, advances the great majority of the value of the receivable upon the sale, and holds back a pre-negotiated portion as a reserve. When the third party gets paid in full from your customer, he pays you back the reserve. The cost of factoring is the difference between the advance you receive up front plus the return of the reserve and the face value of the receivable(s).
Factoring is more expensive than a line of credit, but you can factor even if your credit stinks to high heaven, where as commercial lines of credit has pretty much become extinct in the present financial rats nest.
Factoring is a financial transaction whereby a business sells its accounts receivable (i.e., invoices) at a discount to raise immediate cash. Factoring differs from a bank loan in three main ways.
- First, the emphasis is on the creditworthiness of the company owing you the receivable, not your firm’s credit worthiness.
- Secondly, factoring is not a loan – it is the purchase of an asset (the receivable) in turn for immediate cash.
- Finally, a bank loan involves two parties whereas factoring involves three.
The three parties directly involved are:
- The seller (your business),
- he debtor (your customer),
- And the factor (who buys the receivable, or debt, for cash).
The seller is owed money (usually for work performed or goods sold) by the second party, the debtor. The seller then sells one or more of its invoices at a discount to the third party, the specialized financial organization (aka the factor) to obtain cash. The debtor then directly pays the factor the full value of the invoice.
Factoring of receivables makes sense in general terms if:
- You receivable rich and cash poor
- You can’t get a receivables line of credit from traditional sources
- You are positive you can use the cash from factoring to quickly earn 3 times more profit than the cost of factoring the receivables being factored