Explaining the term “Factoring”
Factoring can be explained as a financial transaction that involves a business job sells out its accounts receivable (called invoices) to a third party (referred as a factor) at a discount. “Advance” factoring involves the factor to provide finance to the account seller in the form of a cash advance, usually 70-85% of the purchase price of the accounts. The balance of the purchase price, along with the net of the factor’s discount fee, and other charges is paid upon collection.
Many a times, the term factoring is synonymously misused with the term invoice discounting. Well, factoring is the sale of invoices while invoice discounting is borrowing at times when receivable is used as collateral.
Usually, there are three parties involved directly in the process –
- the seller of the receivables,
- the debtor (customer of the seller, or the account debtor), and
- the factor
It is noteworthy that the receivable is essentially a financial asset related to the debtor’s liability for paying money payable to the seller. Thereafter the seller sells one or more of its receivables (invoices) at a discounted price to the third party (the specialized financial organization, i.e. the factor), often, in advance factoring to get cash.
The factoring process is used as a method of obtaining cash by the firms. Some companies factor their accounts in case of the cash balance held by them being insufficient to meet the current obligations as well as are unable to accommodate the other cash requirements, like new contracts or orders. However, in some other industries, like apparel or textiles, companies that are financially sound factor t5heir accounts just because it is a conventional method of raising finance. The use of this method to get cash required to accommodate a company’s immediate cash requirements allows the company to maintain a smaller continuing cash balance.
- Counter party credit risk associated with clients and risk covered debtors.
- External fraud by clients, like fake invoicing, pre-invoicing, and misdirected payments.
- Legal compliance and tax risks
- Operational risks
- Uniform commercial code
- IRS liens associated with payroll taxes
- ICT risks (complicated, integrated factoring system, extensive data exchange with the client)