Factor Definition: Requirements, Benefits, and Example

Factor

Investopedia / Sydney Burns

What Is a Factor?

A factor is an intermediary agent that provides cash or financing to companies by purchasing their accounts receivables. A factor is essentially a funding source that agrees to pay the company the value of an invoice less a discount for commission and fees. Factoring can help companies improve their short-term cash needs by selling their receivables in return for an injection of cash from the factoring company. The practice is also known as factoring, factoring finance, and accounts receivable financing.

Key Takeaways

  • A factor is essentially a funding source that agrees to pay a company the value of an invoice less a discount for commission and fees.
  • The terms and conditions set by a factor may vary depending on its internal practices.
  • The factor is more concerned with the creditworthiness of the invoiced party than the company from which it has purchased the receivable.
1:28

Watch Now: What Does Factor Mean in Financing?

Understanding a Factor

Factoring allows a business to obtain immediate capital or money based on the future income attributed to a particular amount due on an account receivable or a business invoice. Accounts receivables represent money owed to the company from its customers for sales made on credit. For accounting purposes, receivables are recorded on the balance sheet as current assets since the money is usually collected in less than one year.

Sometimes companies can experience cash flow shortfalls when their short-term debts or bills exceed the revenue being generated from sales. If a company has a significant portion of its sales done via accounts receivables, the money collected from the receivables might not be paid in time for the company to meet its short-term payables. As a result, companies can sell their receivables to a financial provider (called a factor) and receive cash.

There are three parties directly involved in a transaction involving a factor: the company selling its accounts receivables; the factor that purchases the receivables; and the company's customer, who must now pay the receivable amount to the factor instead of paying the company that was originally owed the money.

Requirements for a Factor

Although the terms and conditions set by a factor can vary depending on its internal practices, the funds are often released to the seller of the receivables within 24 hours. In return for paying the company cash for its accounts receivables, the factor earns a fee.

Typically, a percentage of the receivable amount is kept by the factor; however, that percentage can vary, depending on the creditworthiness of the customers paying the receivables.

If the financial company acting as the factor believes there's an increased risk of taking a loss due to the customers not being able to pay the receivable amounts, they'll charge a higher fee to the company selling the receivables. If there's a low risk of taking a loss from collecting the receivables, the factoring fee charged to the company will be lower.

Factoring is not considered a loan, as the parties neither issue nor acquire debt as part of the transaction. The funds provided to the company in exchange for the accounts receivable are also not subject to any restrictions regarding use.

Essentially, the company selling the receivables is transferring the risk of default (or nonpayment) by its customers to the factor. As a result, the factor must charge a fee to help compensate for that risk. Also, how long the receivables have been outstanding or uncollected can impact the factoring fee. The factoring agreement can vary between financial institutions. For example, a factor may want the company to pay additional money in the event one of the company's customers defaults on a receivable.

Benefits of a Factor

The company selling its receivables gets an immediate cash injection, which can help fund its business operations or improve its working capital. Working capital is vital to companies since it represents the difference between the short-term cash inflows (such as revenue) versus the short-term bills or financial obligations (such as debt payments).

Selling, all or a portion, of its accounts receivables to a factor can help prevent a company that's cash strapped from defaulting on its loan payments with a creditor, such as a bank.

Although factoring is a relatively expensive form of financing, it can help a company improve its cash flow. 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.

The best factoring companies also benefit since the factor can purchase uncollected receivables or assets at a discounted price in exchange for providing cash up front.

Example of a Factor

Assume a factor has agreed to purchase an invoice of $1 million from Clothing Manufacturers Inc., representing outstanding receivables from Behemoth Co. The factor negotiates to discount the invoice by 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 accounts receivable invoice for Behemoth Co. The factor’s fees and commissions from this factoring deal amount to $40,000. The factor is more concerned with the creditworthiness of the invoiced party, Behemoth Co., than the company from which it has purchased the receivables.

Is Factoring a Good Investment?

Determining whether "factoring" is a good investment for a company will depend on many factors, particularly the company specifics, such as the type of business and its financial condition. Generally, factoring is a good investment choice for a business, as it increases liquidity, increases competitiveness, improves cash flow, is efficient, removes the need for good credit, and reduces the reliance on traditional debt.

How Does Factoring Work?

A company that has accounts receivables is waiting on payment from its customers. Depending on the company's finances, it may need that cash to continue operating its business or funding growth. The longer it takes time to collect the accounts receivables, the more difficult it is for a business to run its operations. Factoring allows a company to sell off its receivables at one time rather than having to wait on collecting from customers. The receivables are sold at a discount, meaning that the factoring company may pay the company with the receivables 80% or 90%, depending on the agreement, of the value of the receivables. This may be worth it to the company in order to receive the influx of cash.

How Much Money Do You Need to Start a Factoring Company?

Depending on the type of factoring company you wish to start, your start-up costs will range from $1,135 to $23,259.

Article Sources
Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.
  1. Starter Story. "Start a Factoring Business."