What Is a Factor?
A factor is an intermediary agent that finances receivables. It is essentially a funding source that agrees to pay the company the value of an invoice less a discount for commission and fees. The practice is variably known as “factoring,” “factoring finance,” and “accounts receivable financing.” Factoring offers a valuable source of funding to businesses; it's worth knowing about this option for managing a company's cash flow.
The factor advances most of the invoiced amount to the company immediately, but it only provides the balance upon receipt of funds from the invoiced party. There are three parties directly involved in a transaction involving a factor: the seller of the receivable; the factor, who purchases the receivable; and the debtor, who must now make a payment to the factor, who is the owner of the invoice, rather than to the company.
- 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 with that of the company from which it has purchased the receivable.
How a Factor Works
What is factoring used for? It allows a business to obtain immediate capital based on the future income attributed to a particular amount due on an account receivable or a business invoice. Accounts receivable function as a record of money customers owe for sales made on credit. For accounting purposes they are treated as part of a company’s assets. Factoring allows other interested parties to purchase these as-yet-uncollected assets at a discounted price in exchange for providing cash up front.
Requirements of a Factor
The terms and conditions set by a factor may vary depending on its internal practices. Most commonly, factoring is performed through third-party financial institutions, referred to as “factors.” They often release funds associated with newly purchased accounts receivable within 24 hours. Repayment terms can vary depending on the amount involved. Additionally, the percentage of funds provided for the particular account receivable, referred to as the advance rate, can also vary.
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.
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 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. Although factoring is a relatively expensive form of financing, it helps with a business’ 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.