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Factoring is one form of Accounts Receivable Financing which is the advancing of funds to a company by a lender in anticipation of repayment through their collection of the payments of the company?s invoices (known as accounts receivable). The lender (known as the Factor) will charge a fee which is a combination of interest for the money advanced and their administrative costs of processing the collection of a company?s accounts receivable. The factor will evaluate the type and size of a company?s accounts receivable to determine the general quality of credit of the customer invoices, as well as the invoice volume and amounts which affect administration and processing costs.
Why does a company use this type of financing? It is primarily used to help counter a cash flow problem when the company ?s sales are growing, but customers delay payment thereby impacting the company?s ability to cover day to day costs such as payroll while they are awaiting payment. The company assigns the receivables to the Factor for collection who in turn advances funds to the company prior to the actual payment of the invoice. To do this, the factor assesses the overall risk of the company?s receivable portfolio to determine their risk of not being paid. The business forwards over to the factor?s accounts receivable department all of the necessary information for having their customer payments go to the factor rather than to the company. The factor collects the receivable, regularly reconciles with the company, advances funds to the company and charges a fee.
Factoring may be preferable to using a bank of line of credit as the bank is more conservative about the amount they are willing to loan, especially since they are not processing the accounts receivable for collection and can not closely monitor the receivable quality.. The Factor advances funds as a percentage of booked sales which may fluctuate week to week and assists the business in managing and predicting its cash flow on a regular and periodic basis.
Note that factoring is different than a line of credit that is secured by accounts receivable, as the bank line of credit provides is a flat loan amount available to a company for a period time and independent of the company?s sales growth during that period. In this situation the company may not have sufficient funds week to week as their sales spike and must wait for those receivables to be paid by the customers?..thus the company seeks out the Factor to fill this cash liquidity problem that a secured line of credit may not meet. The bank looks at the company?s creditworthiness which includes a judgment about receivables and possibly inventory and other factors, while the Factor looks solely at the credit worthiness of the receivable as the source of repayment.
There is also a third type of accounts receivable lender that is a somewhat similar to a Factor, but has some key differences. Certain finance companies will purchase just one or two large accounts receivables from a small growing business. Unlike the Factor, they do not process collection of the full receivable portfolio and may only do this on occasion during a period of growth for a small business. |
