Business factoring is when a business sells its accounts receivable at a discount so it can raise money for the business. Factoring is not like bank loans because it is based on receivables. It does not require that you get a loan. And finally, it involves three parties while bank loan just needs two.
Business factoring firms provide a number of services to a seller such as debt collection and managing the accounts receivable ledger. Companies utilize factoring to raise cash flow. It can help in reducing administrative expenses since they take care of the accounts receivable function. Firms who do factoring are referred to as factors or factoring firms.
There are three parties in factoring. These are: the seller, debtor and the factor. What is being sold here is not merchandise or products but receivables. The receivable refers to a document which is part of the company assets which shows that a customer or client owes the company or seller money. The money owed could arisen from services or goods bought.
The seller sells these accounts receivables to a third party, a factor. The selling price is usually pegged lower than its face value. This means the factoring company gives a seller an amount lower than what is on the invoice. The sale of receivables passes the possession of receivables to this factor. Consequently, a factor will assume the risks and rights associated with the receivables. In case of non-payment of the debtor, this factor absorbs the loss.
Factoring is mistaken as invoice discounting at times. These two vary. Factoring involves selling of receivables while invoice discounting merely uses the receivable as collateral for a loan. The biggest difference is that the former is a sale; the latter is a loan.
Factoring is also erroneously called forfeiting. These two business transactions vary in the nature of their transaction. Forfeiting is transaction based while factoring is company based. In forfeiting, the company sells a specific business deal. In factoring, the firm sells accounts receivables or invoices.
In factoring using notification basis, factoring company must tell the debtor about the arrangement between him and the seller. This will enable the factor to collect money from the debtor and receive payments. In notification basis factoring, a seller is not allowed to collect money from the debtor. If he does, the factor might not grant his request for cash advances.
In a factoring transaction is made up of three important parts. First, the money advances made by the seller. The advances is the discounted amount of the receivables paid to the seller. Second, the reserve. This the amount withhold by the factor until full payment of receivable is made. Lastly, the transaction fees. This is the amount deducted to the reserve before the factor pay the seller in full.
In business factoring, the factor may charge service and interest charges not just transaction fees. Interest charges are computed using the length of time needed to receive payments from debtor. These charges are deducted from the reserve money that will be paid to the seller upon collection of debts.
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