What is a 'Factor'
A factor is a financial intermediary that purchases receivables from a company. A factor is essentially a funding source that agrees to pay the company the value of the invoice less a discount for commission and fees. The factor advances most of the invoiced amount to the company immediately and the balance upon receipt of funds from the invoiced party.
BREAKING DOWN 'Factor'A factor allows a business to obtain immediate capital based on the future income attributed to a particular amount due on an account receivable or business invoice. Accounts receivable function as a record of the credit extended to another party where payment is still due. Factoring allows other interested parties to purchase the funds due at a discounted price in exchange for providing cash up front.
The terms and conditions set forth by a factor may vary depending on their own internal practices. Most commonly, factoring is performed through third party financial institutions, referred to as factors. Factors often release funds associated with newly purchased accounts receivable within 24 hours. Repayment terms can vary in length depending on the amount involved. Additionally, the percentage of funds provided for the particular account receivables, referred to as the advance rate, can also vary.
Factoring is not considered a loan, as neither party issues or acquires a debt as part of the transaction. The funds provided to the company in exchange for the accounts receivable is also not subject to any restrictions regarding use.
Example of Factoring
Assume a factor has agreed to purchase an invoice of $1 million from Clothing Manufacturers Inc., representing outstanding receivables from Behemoth Co. The factor may discount the invoice by say 4%, and will advance $720,000 to Clothing Manufacturers Inc. The balance of $240,000 will be forwarded by the factor to Clothing Manufacturers Inc. upon receipt of the $1 million from Behemoth Co. The factor's fees and commissions from this factoring deal amount to $40,000.
Note that the factor is more concerned with the creditworthiness of the invoiced party - Behemoth Co. in the example above - rather than the company from which it has purchased the receivables, Clothing Manufacturers Inc. in this case. Although factoring is a relatively expensive form of financing, factors provide a valuable service to companies that operate in industries where it takes a long time to convert receivables to cash, and to companies that are growing rapidly and need cash to take advantage of new business opportunities.