Factoring is a type of financial transaction that involves a business selling its unpaid invoices to a third party at a discount. This third party is called a factor, hence the name. In essence, the business accepts a sum of money that is less than the value of the invoices for the convenience of receiving a payment right away. Businesses may do this in order to meet immediate cash needs, such as paying employees or bills.
Invoice factoring may also be referred to as accounts receivable factoring and occasionally accounts receivable financing. It is not the same as the process of invoice discounting, which involves using accounts receivable as collateral for a loan.
How does invoice factoring work?
There are a total of three parties involved in any invoice factoring arrangement. The factor purchases the accounts receivable. The business, or seller, sells the accounts receivable, and the debtor, who is required to pay the amount stated on the invoice for goods sold or work performed. When the goods have been sold or work performed, the financial value as indicated by the receivable or invoice is considered an asset.
The goal of this process is to allow the seller to obtain a cash payment, thereby allowing the seller to settle his or her financial obligations, such as the payment of employees. Having business and commercial clients is a common characteristic of companies that participate in invoice factoring. For instance, in manufacturing industries, the need for raw materials to complete work is sometimes greater than the business’s on-hand purchasing assets. As a result, they sell unpaid invoices to obtain the cash required to purchase raw materials. This process is used less often in retail or B2C settings, as business and commercial clients, as no businesses are involved.
Common Terms Related to Invoice Factoring
- Discount Rate. Also known as the factoring fee, this refers to the rate at which the factor purchases the accounts receivable. The discount rate is usually a percentage of the total value of the invoice. For example, a factoring business might decide on a fee of 5% for an invoice that is due in two months. On the other hand, some factoring companies charge per day, per week, or per month. If a company charged 1% per week for an invoice due in two months, they’d end up pocketing 8% of the invoice’s total value.
- Advance Rate. The advance rate refers to the amount of the invoice that is paid upfront by the factoring company. It is always less than the total value of the invoice. The advance rate is used to protect the factor from potential losses. Once the invoice is paid in full by the customer, the factoring company pays the remainder of the balance.
- Reserve Account. Some factors also maintain a reserve account, which reduces any further risk. This account tends to hold 10-15% of the seller’s line of credit. However, this isn’t practiced by all sellers.
- Spot Factoring. Spot factoring is applied to a single invoice, as opposed to an entire accounts receivable.