What is factoring?

Factoring is often used synonymously with accounts receivable financing. Factoring is a form of commercial finance whereby a business sells its accounts receivable (in the form of invoices) at a discount. Effectively, the business is no longer dependent on the conversion of accounts receivable to cash from the actual payment from their customers, which takes place on typical 30 to 90 day terms. Businesses benefit from the acceleration of cash flow.

Factoring is considered off balance sheet financing in that it is not a form of debt or a form of equity. This fact makes factoring more attainable than traditional bank and equity financing.

For example:

A supply company that sells fabric to clothing businesses might create invoices for orders of fabric so that their customers (the clothing businesses) won't have to pay for the order for 30 to 90 days or more. This is great for the clothing businesses as it gives them time to generate cashflow from sales of their clothing. However, for the supply company, it can cause a cashflow bottleneck since they have to wait a month or more for the money to be paid for the invoices.

If the supply company decides to use factoring, they can sell those invoices at a discount in order to keep their cashflow unlocked. This enables them to pay their employees, bills, make repairs, expand the business, extend credit to it's customers, and more.

This can take on a number of different forms. Basically, any kind of situation where goods have been given to the end customer or services have been performed, but money has not yet been paid for the goods or services, is a situation where factoring can be used.

A third party called a "factor" purchases the accounts receivable or invoice at a discount. Why would the factor make such a purchase? For the factor, it is a form of investment. They are willing to wait for the full amount of the payment to be paid by the end customer. To see some of the ways that businesses benefit from factoring, click here.