Factoring is a financial transaction and a type of debtor finance in which a business sells its accounts receivable i. Accounts receivable financing is a term more accurately used to describe a form of asset based lending against accounts receivable. Factoring is not the same as invoice discounting which is called an assignment of accounts receivable in American accounting — as propagated by FASB within GAAP. In the UK the arrangement is usually confidential in that the debtor is not notified of the assignment of the receivable and the seller of the receivable collects the debt on behalf of the factor.

In the UK, the main difference between factoring and invoice discounting is confidentiality. The Scottish Law Commission is [ when? There are three parties directly involved: The sale of the receivable transfers ownership of the receivable to the factor, indicating the factor obtains all of the rights associated with the receivables.

The arrangement is usually confidential in that the debtor is not notified of the assignment of the receivable and the seller of the receivable collects the debt on behalf of the factor. There are four principal parts to the factoring transaction, all of which are recorded separately by an accountant who is responsible for recording the factoring transaction:.

Factoring is a method used by some firms to obtain cash. 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 financing.

The use of factoring to obtain the cash needed to accommodate a firm's immediate cash 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.

Debt factoring is also used as a financial instrument to provide better cash flow control especially if a company currently has a lot of accounts receivables with different credit terms to manage. A company sells its invoices at a discount to their face value when it calculates that it will be better off using the proceeds to bolster its own growth than it would be by effectively functioning as its "customer's bank.

Therefore, the trade-off between the return the firm earns on investment in production and the cost of utilizing a factor is crucial in determining both the extent factoring is used and the quantity of cash the firm holds on hand.

Many businesses have cash flow that varies. It might be relatively large in one period, and relatively small in another period. Because of this, businesses find it necessary to both maintain a cash balance on hand, and to use such methods as factoring, in order to enable them to cover their short term cash needs in those periods in which these needs exceed the cash flow.

Each business must then decide how much it wants to depend on factoring to cover short falls in cash, and how large a cash balance it wants to maintain in order to ensure it has enough cash on hand during periods of low cash flow. Generally, the variability in the cash flow will determine the size of the cash balance a business will tend to hold as well as the extent it may have to depend on such financial mechanisms as factoring.

Cash flow variability is directly related to two factors:. If cash flow can decrease drastically, the business will find it needs large amounts of cash from either existing cash balances or from a factor to cover its obligations during this period of time.

Likewise, the longer a relatively low cash flow can last, the more cash is needed from another source cash balances or a factor to cover its obligations during this time.

As indicated, the business must balance the opportunity cost of losing a return on the cash that it could otherwise invest, against the costs associated with the use of factoring. The cash balance a business holds is essentially a demand for transactions money. As stated, the size of the cash balance the firm decides to hold is directly related to its unwillingness to pay the costs necessary to use a factor to finance its short term cash needs.

The problem faced by the business in deciding the size of the cash Balance it wants to maintain on hand is similar to the decision it faces when it decides how much physical inventory it should maintain. In this situation, the business must balance the cost of obtaining cash proceeds from a factor against the opportunity cost of the losing the Rate of Return it earns on investment within its business.

Today factoring's rationale still includes the financial task of advancing funds to smaller rapidly growing firms who sell to larger more credit-worthy organizations.

While almost never taking possession of the goods sold, factors offer various combinations of money and supportive services when advancing funds. Factors often provide their clients four key services: The outsourced credit function both extends the small firms effective addressable marketplace and insulates it from the survival-threatening destructive impact of a bankruptcy or financial difficulty of a major customer.

A second key service is the operation of the accounts receivable function. The services eliminate the need and cost for permanent skilled staff found within large firms. Although today even they are outsourcing such back-office functions. More importantly, the services insure the entrepreneurs and owners against a major source of a liquidity crises and their equity. The factoring process can be broken up into two parts: Setting up a factoring account typically takes one to two weeks and involves submitting an application, a list of clients, an accounts receivable aging report and a sample invoice.

The approval process involves detailed underwriting, during which time the factoring company can ask for additional documents, such as documents of incorporation, financials, and banks statements.

Factoring, explained

If approved, the business will be set up with a maximum credit line from which they can draw. In the case of notification factoring, the arrangement is not confidential and approval is contingent upon successful notification; a process by which factoring companies send the business's client or account debtor a Notice of Assignment.

The Notice of Assignment serves to. Once the account is set up, the business is ready to start funding invoices. Receivables are funded in two parts. This is deposited directly to the business's bank account. Non-recourse factoring is not a loan. Factoring is like a credit card where the bank factor is buying the debt of the customer without recourse to the seller; if the buyer doesn't pay the amount to the seller the bank cannot claim the money from the seller or the merchant, just as the bank in this case can only claim the money from the debt issuer.

One more difference between the factoring and invoice discounting is that in case of factoring the seller assigns all receivables of a certain buyer s to the factor whereas in invoice discounting the borrower the seller assigns a receivable balance, not specific invoices. A factor is therefore more concerned with the credit-worthiness of the company's customers.

Just a moment

A non-recourse factor assumes the " credit risk " that an account will not collect due solely to the financial inability of account debtor to pay. In the United States, if the factor does not assume the credit risk on the purchased accounts, in most cases a court will recharacterize the transaction as a secured loan.

When a company decides to factors account receivables invoices to a principles factors or broker, it needs to understands the risks and rewards involved with factoring.

Amount of funding can vary depending on the specific accounts receivables, debtor and industry that factoring occurs in. Factors can limit and restrict funding in such occasions where the debtor is found not credit worthy, or the invoice amount represents too big of a portion of the business' annual income.

It's a compound of an administration charge and interest earned overtime as the debtor takes time to repay the original invoice.

Not all factoring companies charge interest over the time it takes to collect from a debtor, in this case only the administration charge needs to be taken into account although this type of facility is comparatively rare. There are major industries which stand out in the factoring industry which are:. The discount rate is the fee a factoring company charges to provide the factoring service. Since a formal factoring transaction involves the outright purchase of the invoice, the discount rate is typical stated as a percentage of the face value of the invoices.

In contrast, companies that do accounts receivable financing may charge per week or per month. The advance rate is the percentage of an invoice that is paid out by the factoring company upfront. The difference between the face value of the invoice and the advance rates serves to protect factors against any losses and to ensure coverage for their fees. Once the invoice is paid, the factor gives the difference between the face value, advance amount and fees back to the business in the form of a factoring rebate.

Whereas the difference between the invoice face value and the advance serves as a reserve for a specific invoice, many factors also hold an ongoing reserve account which serves to further reduce the risk for the factoring company.

While factoring fees and terms range widely, many factoring companies will have monthly minimums and require a long-term contract as a measure to guarantee a profitable relationship. Although shorter contract periods are now becoming more common, contracts and monthly minimums are typical with "whole ledger" factoring, which entails factoring all of a company's invoices or all of the company's invoices from a particular debtor.

Spot factoring, or single invoice discounting, is an alternative to "whole ledger" and allows a company to factor a single invoice.

The added flexibility for the business, and lack of predictable volume and monthly minimums for factoring providers means that spot factoring transactions usually carry a cost premium. Factoring has traditionally operated under a mandatory notification arrangement. Today, many factoring companies also offer a non-notification option that allows sellers to advance their invoices without involving a third party.

In the United States , under the Generally Accepted Accounting Principles GAAP , receivables are considered sold , under FASB ASC or under Statement of Financial Accounting Standards No. Otherwise, the financial transaction is treated as a secured loan , with the receivables used as collateral.

When a nonrecourse transaction takes place, the accounts receivable balance is removed from the statement of financial position.

The corresponding debits include the expense recorded on the income statement and the proceeds received from the factor. Factoring's origins lie in the financing of trade, particularly international trade. It is said [ by whom? Factoring as a fact of business life was underway in England prior to , and it came to America with the Pilgrims, around The latter however evolved by extension to non-trade related financing such as sovereign debt.

This was driven by changes in the organization of companies; technology, particularly air travel and non-face to face communications technologies starting with the telegraph , followed by the telephone and then computers. These also drove and were driven by modifications of the common law framework in England and the United States. Governments were latecomers to the facilitation of trade financed by factors.

English common law originally held that unless the debtor was notified, the assignment between the seller of invoices and the factor was not valid. The Canadian Federal Government legislation governing the assignment of moneys owed by it still reflects this stance as does provincial government legislation modelled after it. As late as the current century, [ when? In the United States, by the majority of state governments had adopted a rule that the debtor did not have to be notified, thus opening up the possibility of non-notification factoring arrangements.

Originally the industry took physical possession of the goods, provided cash advances to the producer, financed the credit extended to the buyer and insured the credit strength of the buyer. With the development of larger firms who built their own sales forces, distribution channels , and knowledge of the financial strength of their customers, the needs for factoring services were reshaped and the industry became more specialized.

By the twentieth century in the United States factoring was still the predominant form of financing working capital for the then high growth rate textile industry. In part this occurred because of the structure of the US banking system with its myriad of small banks and consequent limitations on the amount that could be advanced prudently by any one of them to a firm. Even then factoring also became the dominant form of financing in the Canadian textile industry. By the first decade of the twenty first century a basic public policy rationale for factoring remains that the product is well suited to the demands of innovative rapidly growing firms critical to economic growth.

In the latter half of the twentieth century the introduction of computers eased the accounting burdens of factors and then small firms. The same occurred for their ability to obtain information about debtor's creditworthiness. Introduction of the Internet and the web has accelerated the process while reducing costs. Today credit information and insurance coverage are instantly available online.

The web has also made it possible for factors and their clients to collaborate in real time on collections. Acceptance of signed documents provided by facsimile as being legally binding has eliminated the need for physical delivery of "originals", thereby reducing time delays for entrepreneurs. Traditionally, factoring has been a relationship driven business and factoring transactions have been largely manual and frequently involving a face to-face component as part of the relationship building process or due-diligence phase.

This is especially true for small business factoring, in which the factoring companies tend to be locally or regionally focused. To make the arrangement economically profitable, most factoring companies have revenue minimums e. More recently, several online factoring companies have emerged, leveraging aggregation, analytics, automation to deliver the benefits of factoring with the convenience and ease afforded by the internet. This enables them to serve a broader range of small businesses with significantly lower revenue requirements without the need for monthly minimums and long-term contracts.

The emergence of these modern forms has not been without controversy. Critics accurately point out that none of these new players have experienced a complete credit cycle and thus, their underwriting models have not been market tested by an economic contraction. What's more, some of these new models rely on a market place lending format.

It's unclear if this source of capital will be stable over time, as other companies, most notably, Lending Club , had a difficult time attracting investors in early , even though net returns seem higher on invoice finance platforms such as MarketInvoice [40] than on business loan platforms such as Funding Circle.

With advances in technology, some invoice factoring providers have adapted to specific industries. This often affects additional services offered by the factor in order to best adapt the factoring service to the needs of the business. These differences can affect the cost of the facility, the approach the factor takes when collecting credit, the administration services included in the facility and the maximum size of invoices which can be factored.

Since the United States recession one of the fastest growing sectors in the factoring industry is real estate commission advances. Commission advances work the same way as factoring but are done with licensed real estate agents on their pending and future real estate commissions.

Commission advances were first introduced in Canada but quickly made its way to the United States. Typically how the commission advance process works is they apply online, sign contracts selling their future real estate commissions at a discount, and then the funds are wired to their bank account. The healthcare industry makes for a special case in which factoring is much needed because of long payment cycles from government, private insurance companies and other third party payers, but difficult because of HIPAA requirements.

For this reasons medical receivables factoring companies have developed to specifically target this niche. Factoring is common place in the construction industry because of the long payment cycles that can stretch to days and beyond. However, the construction industry has features that risky for factoring companies.

Because of the risks and exposure from mechanics liens , danger of "paid-when-paid" terms, existence of progress billing, use of withholding, and exposure to economic cycles most "generalist" factoring companies avoid construction receivables entirely. That has created another niche of factoring companies that specialize in construction receivables. Factoring is often used by trucking companies to cover upfront expenses, such as fuel.

Factoring companies that cater to this niche offer services to help accommodate truckers on the road, including the ability to verify invoices and fund on copies sent via scan, fax or email, and the option to place the funds directly onto a fuel card, which works like a debit card.

Trucking factors also offer fuel advance programs that provide a cash advance to carriers upon confirmed pickup of the load. Large firms and organizations such as governments usually have specialized processes to deal with one aspect of factoring, redirection of payment to the factor following receipt of notification from the third party i.

Many but not all in such organizations are knowledgeable about the use of factoring by small firms and clearly distinguish between its use by small rapidly growing firms and turnarounds.

Distinguishing between assignment of the responsibility to perform the work and the assignment of funds to the factor is central to the customer or debtor's processes. Firms have purchased from a supplier for a reason and thus insist on that firm fulfilling the work commitment. Once the work has been performed however, it is a matter of indifference who is paid. For example, General Electric has clear processes to be followed which distinguish between their work and payment sensitivities.

Risks to a factor include: In reverse factoring or supply chain finance, the buyer sells their debt to the factor. That way, the buyer secures the financing of the invoice, and the supplier gets a better interest rate. From Wikipedia, the free encyclopedia. Retrieved 25 July Shim, "The Vest Pocket CPA", Wiley, Retrieved 27 July Goodman, "Dictionary of Finance Investment Terms", Baron's Financial Guides , Retrieved 9 April Citation - Manufacturers' uses of Factoring?

Retrieved 7 July Baumol, The Quarterly Journal of Economics , November , — However, as mentioned, there are periods of time in which cash flow can be negative more cash flows out than in. The 10 Most Misunderstood Cost Drivers" PDF. Federal National Commercial Credit. Retrieved 20 June In other words, the nonrecourse factor who assumes credit risk bears the credit loss and incurs bad debt if a purchased account does not collect due solely to financial inability of the account debtor to pay.

Retrieved 23 November Factoring and Accounts Receivable Discounting. An Evidence from the Egyptian Market".

How to Profit from Factoring

International Finance and Economic Imperialism in Egypt; Landes, David S. How to Run a Small Factoring Company. Retrieved June 27, The World's Oldest Method of Finance Goes Online". Retrieved December 5, Non-Bank Financial Institutions and Capital Markets in Turkey. Retrieved 13 March Retrieved from " https: Corporate finance Fundamental analysis Accounting terminology Working capital management Accounts receivable.

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