Factoring – An Important Screw in the Financial Wheel

Every business would wish to deal in only cash sales all the time but an entrepreneur is hardly in a position to insist on this particular point because in most cases majority of customers prefer buying products on credit. In such a scenario, firms and companies draw out their own credit policies and categorize their customers in terms of their creditworthiness. However, making too much sales on credit can dry out the liquid reserves of a company making it hard for it too meet immediate obligations and short-term expenses. This is where many firms turn to factoring.

In a nutshell, factoring refers to the sale of a firm’s accounts receivable to a person or entity called ‘factor’ at a discount. The concept of factoring is perfectly understandable as firms whose sales mostly constitute credit sales often run out of cash to get their business running and instead of waiting for their accounts receivable to mature they choose to sell these book debts at a discount to a third party. The third party, commonly named as the ‘factor’ finds its motivation in this transaction in that it buys the accounts receivable from a firm at a discount.

When you think of it, in factoring, it is the ‘factor’ who bears the real risk as a result companies that undertake factoring keep in view a number of key factors before they actually enter a factoring agreement with their clients. Contrary to the common perception, the financial soundness of the client entity is not that important in the decision making process as is the creditworthiness of the potential debtors named in debt invoices. By analyzing key documents such as customer crediting aging reports and terms of credit, the factor decides if it is profitable to go through with a particular factoring arrangement.

There are different types of factoring that have evolved over the years as this financing practice can be traced back to 1400s in England. Under basic factoring, the client entity receives a substantial percentage of the total face value of the account receivables immediately by the factor, while the remaining amount is disbursed once the debts have been fully repaid by the original debtors. Not to mention, the factor retains the service charges while paying the remaining amount to its client.

Full service factoring is mostly popular with businesses that are newly established. Under this type of factoring, the factor apart from entering into a continuous factoring relationship with its client also provides other services such as debt administration, risk coverage and so on. What makes full service factoring so popular with new businesses is the fact that under this arrangement factors assume full risk of non-payment of the debts. Some of the other types of factoring include invoice discounting, recourse factoring and industry-specific factoring.

In recent times the concept of reverse factoring has also gained popularity but as the name suggests it is initiated not by the supplier but by the ordering party. In most cases customers use reverse factoring to facilitate the supplier to make the delivery by having the payment secured by a factor at a relatively low discount rate.