The Basics: An Introduction to Factoring

Accounts Receivable Factoring or simply factoring, is a powerful financial tool used worldwide as a method of business finance and more specifically, to address the cash flow problems which arise when a business sells on “open terms” and provides terms of payment to customers.  By “terms of payment”, we refer to the time one business grants to another to pay for goods delivered or services performed.  It is important to understand that when one business allows a customer 30, 45, 60 days or longer to pay for a delivery or services, they are actually providing a type of inventory finance to that customer.

Because factoring is only utilized to address the working capital problems which arise when granting extended time for customers to pay for shipments or services, it is generally considered to be a business-to-business (B2B) form of finance and not consumer related.  Plain and simple, factors only finance invoices due and payable by business.  They do not finance real estate, notes, vehicles, franchise purchases, etc.  They do not provide start up cash or loans of any kind.  Factors only finance invoices payable from one business to another or B2B financing.

While certainly not a household word, factoring in the United States is an enormous industry with a current sales volume of approximately $130 billion annually.  For many startup and “first stage” businesses having little access to traditional bank financing, factoring simply has no equal in its capacity to free up working capital for growth and business expansion.

When first introduced to its many characteristics as a proven form of business finance, it is important to make immediate note as to the major differences between factoring and the more commonplace methods of commercial finance such as business term loans and asset-based lending.   As it is traditionally recognized, factoring is never a loan.  It always involves the actual purchase of the accounts receivable of a business at a small discount to their face value.  Contrarily, asset-based lines of credit are always structured as a loan and though many modern day factors have developed some rather exotic hybrid fee and purchase structures for their financing models, the financial basis for these transactions is always that of purchase and sale rather than loan and repayment.

With the basis for such financing predicated entirely upon the accounts receivable (the invoices) of a business as collateral, factors differ markedly from banks and other traditional lenders that will provide business loans based on more typical collaterals such as real estate, equipment, inventory, and buildings or other structures.  In essence, factors simply buy invoices…short-term obligations owed by one business to another for goods and services delivered or performed.

Since factors purchase accounts receivable, they own them.  And, because of their actual ownership of the purchased invoices or accounts receivable, factors tend to become very involved in the day-to-day operations of their client’s business and often perform most functions of collection and accounting.  They will be in periodic contact with customers ( known in the industry as account debtors) to make certain timely payment is made upon the invoices purchased by the factor and, in most cases, will insure that payments upon the invoices will be mailed to the business address (or lockbox) of the factor rather than to the address of the client or the business selling the invoices.

So to sum up the basic characteristics of factoring:

  • Factoring is never a loan, but rather a purchase and sale transaction.
  • Factoring is a business-to-business (B2B) transaction and typically does not involve consumers.
  • Factors only purchase invoices (accounts receivable). The do not provide financing for equipment, real estate, business startup seed requirements, etc.
  • Factors only purchase invoices representing goods actually delivered or services actually performed.  They additional do not purchase delinquent invoices of invoices of questionable quality.
  • Factors will become directly involved in collections and accounting regarding invoices purchased.
  • In most cases, payments from customers will be directed to the factor’s business address or a bank lockbox.