Often times, new, inexperienced brokers will tell a client they need a “factoring loan” to help them solve their cash flow problems or assist in generating the cash necessary for payroll. For the most part, however, referring to factoring as any type of “loan” is simply incorrect. An important distinction, all brokers and commercial finance consultants should understand the obvious differences between factoring vs. lending.
Factoring is easily distinguished from the more common methods of business finance provided by most banks in that true factoring is never a structured as a loan, but rather as a purchase and sale transaction. Also, since factoring only relates to invoiced sales, it is strictly a method of financing business-to-business or B2B transactions. It is very important for brokers to understand that factoring is not used to directly finance retail consumer transactions. Understandably, when immediate payment is received by cash or credit card at time of sale, there is no invoice or extension of payment terms and factoring would be, by definition, unnecessary.
Factoring vs. Lending: Number of Parties Involved
Another way to compare factoring vs. lending is to look at the number of parties involved. Rather than just the two parties commonly involved in an normal business loan (the borrower and lender), there are always three parties involved in any factoring transaction. These are the:
- client…the seller of the invoices
- factor…the buyer of the invoices
- account debtor…the client’s customer obligated to make payment upon the invoices
Working capital generated by factoring business accounts receivable can be used for hundreds of purposes such as buying equipment, paying suppliers, purchasing inventory, etc. The factoring process itself is only utilized for one thing, however, and that is to provide a method of financing extended terms of payment for customers. Financing sales made to customers on credit terms is an essential component of good cash flow management. Factoring provides that financing solution for small businesses worldwide.
The use of the term “factoring” has also grown over the years to include any financial transaction which involves discounting such as those found in the Cash Flow Industry. For example, buyers of structured settlements are said to “factor” the annuitized structured settlement payment streams when making lump sum annuity purchases. Credit card companies are said to be factors due to the discount charged to the merchant for guarantying the payment made by a consumer. For your purposes as an industry broker, however, the discussion of factoring should simply reference the discounted purchase of business trade receivables by a finance company in a non-loan purchase and sale transaction.
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