The concept of factoring is nothing but a financial transaction. It is also known as debtor finance, where a business sells the invoices to a third party or factor at a discounted rate. Companies require consulting factors for the receivable assets to meet the immediate cash needs.
A factor is but an intermediary agent who provides financing to the companies by buying the account receivables. The practice of factoring is also known as accounts receiving financing or factoring finance.
The process allows a business to obtain capital based on the future income attributed to an amount due on a business invoice or receivable account. The receivable accounts represent money that the customers owe to the company for sales made on credit.
Types of Factoring
There are two types of factoring. The details are given below.
- Resource factoring
Here, the clients need to buy back unpaid receivable bills from the factors.
- Non-resourcing factoring
Absorb for unpaid invoices is not involved here
- Domestic factoring
In this specific category, the client, the customer, and the factor are present in the same country.
Functions of Factoring
All the factoring companies perform various functions as they finance for the supplier, including advance payments and loans. Sometimes they need to maintain a sales ledger. They offer protection against payment default by debtors. The collection of receivables is another function of factoring.
Factoring is crucial for it helps companies to develop their short-term cash requirements. The receivables are recorded as current assets on the balance sheets for accounting purposes.
What Is The Requirement For Factoring?
Companies often experience cash flow shortfalls when their account bills or short-term debts exceed sales revenue. In this situation, the companies can sell the receivables to a factor or financial provider to receive cash.
The factor keeps a percentage of the receivable with him. This amount may vary depending upon the creditworthiness. When a company sells the receivables, it transfers the default risk to the factor. Factors may charge remuneration as compensation.
Example of Factoring in Finance
Factoring is one of the best courses of action for a company. A company can grow in no time by using the factoring method.
Suppose a company ‘Z’ has three significant clients, namely A, B, and C. Z, supplies products regularly to these three companies. However, often they pay after a month of the shipment. The process is adversely affecting Z’s growth, and so it cannot pay salaries to the employees.
Now, it decides to sell the receivables or invoices to a factor. They provide the invoice copy to the element ‘F.’ After approval, F pays 80% of the receivables to Z. Now, F starts to act as the account receivable department and begin servicing the invoices themselves. When the client pays 100% to F, it sends the remainder to Z and removes the fees. It eliminates all worry about payroll.
The unpaid invoices create a hindrance to business growth. Factoring helps solve this problem in a short time.