**Definition**

Accounts receivables factoring is designed to finance ventures without increasing leverage in the business. It involves selling of invoices to third parties at discount and colleting finance. Generally, it helps the businesses to finance working capital.

**Detailed explanation**

A sale made on credit is recorded on the general journal as a credit to the goods/services sold and a debit on the accounts receivable side. The company issues an invoice to the customer to indicate an outstanding payment for the shipment made in advance. Such payments usually take some time like a month or 90 days to get cleared. This is an acceptable period unless the company urgently requires cash-in-hand for carrying out certain business operations. Here comes accounts receivable factoring, also known as invoice factoring, as an effective strategy to convert tied-up capital into working capital quickly.

**How does it work?**

There are two parties involved in this transaction, one is the accounts receivable selling company and the other is the accounts receivable buying company known as the ‘factor’. The selling company sells its receivable invoices to the factor and receives a major portion of the due payment (80-90%) in return. On the other hand, the factor company, charges a factoring fee from the selling company and collects the receivables from the customers, also bearing the risk of non-payment (non-recourse factoring). Once the payment is received, the factor company sends the remaining amount of receivables to the invoice selling company after deducting its factoring fees.

**Recourse and Non-Recourse Factoring**

Factoring can be of two types,

**Recourse factoring**is when the receivables selling company shares the risk of default payments with the factor such that it will be entitled to pay the unpaid amount to the factor on behalf of its customers. Comparatively, less factoring fee is charged in this case.**Non-recourse factoring**is when the receivables selling company does not share the risk of uncollected receivables with the factor. In this case, the factor company charges higher factoring fees as it is solely bearing the liability.

**Factoring Fee**

The factoring fee is charged as a percentage of the amount of receivables. It might be charged as a fixed or variable rate depending on the following factors:

- The creditworthiness of the company’s clients
- The amount of the receivables
- The remaining duration for the invoices to be paid off in the case of variable rate.
- The industrial sector in which the company operates.

Variable factoring fees might be charged on a monthly or weekly basis. For example, if a 3% rate is charged every month and payment is received after 3 months then the rate would compound and become 9% of the receivable.

**Accounts receivable factoring example**

Suppose you run an electronics company. In the month of September, you sold 5 desktop systems on credit to a customer amounting to $7,000. The customer is likely to pay the invoice after 1-2 months in October or November. But you just received another order of 10 desktop systems. Now, you lack the working capital required to fulfill this order so you think of accounts receivable factoring as a good way to obtain immediate cash. Therefore, you contact a factoring company that agrees to buy your receivables on recourse and pays you 80% of the invoice amount right away, also charging a factoring fee of 2% every month from the remaining amount. After a month in October, your customer pays the amount, $7,000 to the factor company. Following with be the cash flows pertaining to this transaction in the months of September and October.

Transaction 1 = Cash inflow in September = $7000 * 80% = $5,600

Transaction 2 = Factoring fees deduction = $7000 * 2% = $140

Transaction 3 = Cash inflow in October = $7000 * 20% = $1400 – $140 = $1260

In the first transaction, advance is received from factoring company which is the purpose of factoring activity. Similarly, in the third transaction, remaining 20% is paid by the factoring. However, it’s paid after deducting factoring fee which was calculated in transaction 2.

**Accounts receivables factoring benefits**

Accounts receivables factoring has following advantages,

- The prime benefit of factoring over financing is that it does not limit to good credit ratings. The factor company does not run a credit check on your company so it becomes a suitable option if your company is new or is suffering from bad credit due to some economic downturns or financial crises. In fact, factoring can help improve credit scores if the factor company reports your repayments to a credit reporting agency.
- Receivables factoring also saves your business from getting into long-term debt obligations.
- Factors run credit checks on your company’s clients reassuring their creditworthiness. Also, the customers are more likely to repay to factors due to their reputation and debt control systems.
- In the case of non-recourse factoring, your company is discharged from the liability of uncollected receivables and the factor is responsible for chasing bad debtors. It can be beneficial approach if customer goes bankrupt.
- With invoice factoring, your business will never have to miss out on opportunities like taking up a new project or buying inventory at discount due to a lack of working capital.
- It is a fast and convenient method to obtain finances.

**Accounts receivables factoring drawbacks**

Factoring also has some disadvantages that include but not limited to followings,

- On the downside, you have to pay a portion of your receivables as factoring fees resulting in a low profit margin.
- In the case of recourse factoring, your company is liable to repay the factor if your customer defaults on payment.
- The factor-customer relationship can affect your business operations as some customers might not like the factors methods for collecting invoices. Additionally, you might have to consider the factor’s approval in choosing business clients.

Thus, a company should analyze the pros and cons of factoring and weigh it against its business needs before taking on an accounts receivables factoring strategy.

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