Factoring is the process of selling accounts receivable at a discount. It is a credit service designed to turn assets into cash, but it is not a loan. The client business benefits from factoring its account receivables in three ways.
1. The sale improves the business’s liquidity because the company receives cash almost immediately upon the creation of the invoice.
2. The client business does not need to incur the expense of a credit and collections department because these functions are performed by the factor.
3. Conventional financing may not be available to these companies, which leaves factoring receivables as their only source of growth financing.
HOW FACTORING WORKS
Most business sales result in the creation of an invoice, which states the terms and conditions for payment of the goods or service. Sometimes these invoices are paid immediately. More often, however, they are paid over some period of time, typically 30, 60, or 90 days. At the time of invoice creation, the selling company books an entry to its accounts receivable. Factors takes advantage of the value created by the invoice or receivable by paying cash for the right to receive future payments from the client's customers (called “debtors” in the factoring world).
Factoring solves the problem for growing businesses that tie up cash through added working capital requirements. For example, if PrivateCo grows its sales by $3 million from one year to the next, and its customers pay in 60 days ...