'Factoring' is explained in detail and with examples in the Corporate Finance edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
Factoring refers to a financial transaction which is considered to be debtor finance. In such an arrangement, companies actually sell off their invoices or accounts receivable to a third party factor for a discount. There is a major reason why a company would be interested in doing this. They may require cash for immediate needs which cannot wait for the accounts receivables to be effectively paid. When exporters engage in selling off their receivables in international trade finance, this is alternatively known as Forfaiting.
Factoring itself is typically also called invoice factoring, accounts receivable factoring, and accounts receivable financing. The foremost trade association for factoring proves to be the Commercial Finance Association. It handles both factoring transactions as well as asset based lending.
It is important to differentiate between factoring and invoice discounting. With factoring, receivables are actually sold off. Invoice discounting refers to a form of borrowing that utilizes for collateral on the loan the various accounts receivable assets. This is not the case in the United Kingdom however. Discounting is a type of factoring in the British market, which merely pertains to assigning receivables. This means that in Great Britain, this activity is also not deemed to be a form of borrowing. Confidentiality proves to be the principle difference between invoice discounting and factoring in the United Kingdom.
Four main events cover the factoring transaction. Each of these must be accountant-recorded by the individual financial professional who bears the responsibility for recording the transaction in its entirety. In the first step, the factor receives its fee. Next the interest expense must be paid out to the factor for advancing money on the transaction.
In the third step, the seller must allocate a certain percentage of the fees as bad debt expense. This relates to those receivables which the seller does not have confidence in being collectible. Finally, the seller will have to arrange a merchandise returns amount in the form of a “factor’s holdback receivable.” This category also covers any potential other gains or losses the seller will be forced to concede to the process of the invoice collecting.
There will be times when the charges the seller pays out to the factor will cover considerations such as extra credit risk, a discount fee, and additional services rendered by the factor. The final profit for the factor will amount to the ultimate difference between the amount it paid to obtain the invoices on accounts receivable and the actual money it finally recovers from the debtors. Any money which the factor loses because of non-payment is subtracted from this profit total.
With industries like clothing and textiles, companies which are completely financially sound will factor off their accounts. This results from the particular historical means of financing production in this industry. It permits the firm to cover its current cash needs and allows companies to operate with lesser cash balances. This leaves a larger amount of cash free for investing in future growth opportunities of the firm.
This debt factoring also serves a useful purpose as a means of improving cash flow control for those firms that find themselves in the unenviable position of possessing many accounts receivable that have various terms of credit which must be actively managed. Such a firm will often sell off its invoices at the appropriate discount because it decides that it will benefit financially in utilizing the resulting proceeds to improve growth. This serves them better than in acting as a de facto bank to their various clients.
This effectively means that factoring will happen at any point in any industry where the return rate for the proceeds put into future production is higher than the costs to factor out the receivable accounts. This is why the difference in money spent to factor must be carefully evaluated to ascertain if the value of producing additional goods will be higher than the money the company pays to work with the factor. A side but still important consideration revolves around how much cash the company possesses on hand for its operations and future growth potential.