Factoring

Factoring 

Factoring is a financial service designed to help firms to arrange their receivable better. Under a typical factoring arrangement a factor collects the accounts on due dates, effects payments to the firm on these dates and also assumes the credit risks associated with the collection of the accounts.
 Sometimes the factor provides an advance against the values of receivable taken over by it. In such cases factoring serves as a source of short-term finance for the firm.

Type of financial service whereby a firm sells or transfers title to its accounts receivable to a factoring company, which then acts as principal, not as agent. The receivables are sold without recourse, meaning that the factor cannot turn to the seller in the event accounts prove uncollectible. Factoring can be done either on a notification basis, where the seller's customers remit directly to the factor, or on a non-notification basis, where the seller handles the collections and remits to the factor. There are two basic types of factoring:

1. Discount factoring arrangement whereby seller receives funds from the factor prior to the average maturity date, based on the invoice amount of the receivable, less cash discounts, less an allowance for estimated claims, returns, etc. Here the factor is compensated by an interest rate based on daily balances and typically 2% to 3% above the bank prime rate.

2. Maturity factoring arrangement whereby the factor, who performs the entire credit and collection function, remits to the seller for the receivables sold each month on the average due date of the factored receivables. The factor's commission on this kind of arrangement ranges from 0.75% to 2%, depending on the bad debt risk and the handling costs.

Factors also accommodate clients with "overadvances," loans in anticipation of sales, which permit inventory building prior to peak selling periods. Factoring has traditionally been most closely associated with the garment industry, but is used by companies in other industries as well.

Factoring is a form of financing in which a business sells its receivables to a third party or "factor company" at a discounted price. Under this arrangement, the factor agrees to provide financing and other services to the selling business in return for interest and fees on the money that they advanced against receivables invoices. Businesses in need of cash can thus secure up to 80 percent of the receivables' face value (a higher percentage can sometimes be secured, but in most instances 20 percent is held in reserve until the account balances are paid off).

Factoring is a favorite capital raising choice for established small business owners. "A factor company can be a useful source of funds if you are already in business and have made sales to customers," indicated the SBA publication Financing for the Small Business. "Factor companies purchase your accounts receivable at a discount, thereby freeing cash for you sooner than if you had to collect the money yourself." Factor companies can either provide recourse financing, in which the small business is ultimately responsible if its customers do not pay, or nonrecourse financing, in which the factor company bears that risk. Factor companies can be a useful source of funds for existing businesses, but they are not a realistic "seed money" option for startups because such businesses do not yet have a base of customers—or accounts receivable—to offer.

in finance, the selling of accounts receivable on a contract basis by the business holding them—in order to obtain cash payment of the accounts before their actual due date—to an agency known as a factor. The factor then assumes full responsibility for credit analysis of new accounts, payments collection, and credit losses. Factoring differs from borrowing in that the accounts receivable and the responsibility for their collection are actually sold rather than merely offered as loan collateral. Factoring is employed especially by highly seasonal industries to shift the functions of credit and collection to a specialized agency.

Types of factoring

Notified, or full service factoring

With notified factoring, the clients debtors are aware of the finance facility as the factoring company normally does the credit control, that is, collects the outstanding debts.

Confidential, or invoice finance

With invoice finance, the facility is confidential, with the client company retaining the credit control function.

Recourse factoring

Recourse factoring is now the most common type of factoring transaction. This factoring transaction allows the factor to go back to the seller if payment is not received (normally after a 90 day period). The credit risk does not transfer to the factor during the recourse factoring process.

Normally, in the event of non-payment by the customer, the seller must buy back the invoice with another invoice (credit worthy). Recourse factoring is typically the lowest cost for the seller because the risk for the factor on the funding transaction is lower.

Non recourse factoring

Non recourse factoring puts the risk of non-payment, in the event the customer becomes insolvent, fully on the factor. If the customer can not pay the invoice due to insolvency, it’s the factor's problem to deal with and they cannot seek payment from the seller. The factor will only purchase solid credit worthy invoices and often turns away average credit quality customers. The cost is typically higher with this factoring process as the factor assumes greater risk.

New Company Factoring

Sometimes, because a company is new, it may find it difficult to secure traditional bank financing. An alternative source of financing that is becoming more popular for small or new companies is called factoring. Factoring is the sale of accounts to a finance company (the factor) in order to gain immediate access to the cash owed to it by its customers. Instead of sending bills directly to the customer, the company sends its invoices to the factor, who immediately pays the company–thereby eliminating the 30, 60, or even 90 days of waiting that normally follows a billing cycle.

For example, suppose a manufacturing company secures a contract to sell its widgets to a large retailer. Upon delivery of the merchandise to the retailer, it sends the bill through the factoring company for payment. The factor pays the manufacturer the face value of the invoice less a discount fee (2–10%) depending on the nature of the contract and the creditworthiness of the retailer. This immediate access to the cash flow allows the manufacturer to meet its commitments and pay its bills in a timely manner. The retailer pays the factor when the bill comes due for the widgets it purchased from the manufacturer.

Factoring can be a very expensive source of financing and is only recommended to companies that are growing faster than their current financing permits. Because factoring can be expensive, many companies use it only as a financing means of last resort. Factoring allows a company in financial difficulty to focus attention on the operations of its business as opposed to spending time and resources focused on how it will make payroll, for example. Depending on the state of the firm, factoring can be a useful financial tool; one that business owners should explore.

Factoring has been available to a variety of companies for many years. Some factors specialize only in retail financing, others specialize in freight-bill factoring for trucking companies, and others only factor invoices for manufacturing companies. Factoring may be more expensive than traditional bank financing but often it is the only source of financing that some new or under-capitalized companies can find.

Prior to the 20th century a factor was a business agent whose functions included warehousing and selling the commodities that were consigned to him, accounting to his principals for the proceeds, guaranteeing the credit of purchasers, and sometimes making cash advances to his principals before the actual sale of the goods took place. His services were of particular value in foreign trade, and factors became important figures in the great period of colonial exploration and development.

Although most modern factoring is in the textile field, factors are also used extensively in the shoe, furniture, hardware, and other industries, and the trade areas in which factors operate have increased. Factors are concentrated mainly in New York City, but their clients are scattered throughout the United States and Europe. Although factors have almost always been entirely commercial enterprises, some banks have entered the field through the acquisition of established factoring organizations, as well as by opening their own factoring departments.