Factoring is a type of debtor finance. It is a financial transaction between a company and a factor or factoring firm. In the simplest sense, factoring allows a business to sell Accounts Receivable (AR) to a third party, at a concession/discount to the buyer.

Factoring is a quick way for a business to fund its impending cash needs. Also, a business can boost its working capital by factoring receivable assets. Factoring is also associated with the terms invoice finance, receivables financing, asset based lending and debt factoring.

The Process Behind Factoring

Factoring relieves the business from debt by providing less than the total amount. Therefore, the business gets the means to continue its trading and services with sufficient working capital. However, most individuals and businesses prefer learning about the process of factoring before taking part in it.

Here is how factoring works,

• A client (first party) can obtain a service from a business (second party) without paying upfront. The business then provides an invoice. Hence the business gathers Accounts receivable. Though the client eventually pays the full amount, the business gets a smaller working capital for immediate tasks.
• The business can now seek a factoring company (third party) and enter an agreement. The factoring company then purchases the Accounts Receivable for a discount. And funds the cash flow of the company. The business usually gets an advance between 70% to 85% of the debt.
• The factor then follows up on the debt for the full amount of the service. Hence when the total amount has been settled, the factor gains a profit. Finally, the factoring company will pay the business the remaining amount, once the debt has been settled.

At a glance, factoring frees the second party/business from a debt. Thereby, the business gains the potential to continue its services. This process is quite common among exporters.

Pros and Cons of Factoring

The process of factoring comes with its own set of advantages and disadvantages.

• Pros

For a certain profit, a factoring company can free a business of the debt collected in unsettled invoices. This increases the cash flow of the company without waiting for the customer to pay up. Hence, for a business using factoring, maintaining sufficient working finance is easier.

The factoring company will also chase the debtor for payments. This relieves the business of the responsibility of collecting payment. Thereby saving admin time.

• Cons

Most of the factoring companies hold businesses in long contracts. Also, all of the sales ledger of the business must be funded by the factoring company. The contract can also be costly and prove hard to get out of.

This can be an expensive form of finance. Though the factoring company provides amicable rates and fees at the start, it can get costly later. The factoring company may introduce extra fees per month and this can result in a considerable expenditure.