Factoring Overview

Accounts receivable financing, also known as factoring is a very popular form of asset based lending. Factoring involves a factor (company that offers factoring services) purchasing an organization's accounts receivable at a discounted rate. The factoring company then takes control of the receivable and collects from the buyer.

The Factoring Process and Steps Involved

To better understand the factoring process we will go into a detailed description of all the parties involved and each step of the factoring process. Here are the parties involved in a standard factoring transaction.

Parties Involved

  • Buyer - This is the firm purchasing products. This might be a retailer purchasing products from a distributor, or manufacturer purchasing raw materials.
  • Seller - This is the firm selling the products.
  • Factor or Factoring Company - The company that will purchase the receivable from the seller.

The Factoring Process
The below points correspond to the lettered steps on the diagram below.

  • A - The buyer submits a purchase order to the seller for $10,000 dollars worth of product.
  • B - The seller produces the product and delivers the product to the buyer. Once the product is delivered, the seller has an account receivable meaning that they buyer is liable for payment. Without factoring the seller may have to wait anywhere from 20 to 60 days to receive payment from the buyer.
  • C - In this case, the seller decides they don't want to wait to receive payment and decides to involve a factor. The factor would then purchase the open account receivable from the seller at a discounted rate. In this case the factor offers the seller 95 percent of the value of the invoice and a discount rate of 1.4 percent. Therefore, the seller receives $9,500. The 5 percent or $500 will become the reserve balance which is the factor's way of hedging their risk. Of that 5 percent, 1.4 percent is the profit for the factor and cost to the seller.
  • D - Now the buyer pays the factor the full $10,000. Once the factor receives the full payment for the invoice the return a portion of the $500 reserve balance to the seller since they no longer need to hedge their risk. The factor keeps $140 of the reserve balance and this is the profit for the factoring company.

This example covers the majority of factoring transactions, but some can be more complex. We will explain parts of this process in greater detail as a part of this lesson.

More Factoring Examples

Different types of businesses use factoring in different ways. Some use factoring to avoid bankruptcy, while others use factoring to help finance large orders that their company is not prepared to fulfill. Below are several examples of how different types of companies use factoring:

Example 1 - Grey Dog Trucking

Factoring is frequently used in the transportation industry. Smaller trucking companies often use factoring when their cash balances are running extremely low and they need to boost their working capital.

For this example we will use Grey Dog Trucking, a trucking company out of Florida with 6 trucks. In this example the company's cash balance is down to $1200 and they have an opportunity to transport a load to Washington worth $2000. However, it will take $1000 worth of fuel to make it Washington. Instead of dangerously decreasing their cash balance to $200 they decide to factor this transaction in order to maintain a healthier balance sheet. In this case, a factoring company purchases Grey Dog Trucking's receivable for $1900 and provides the capital the needed to deliver the load to Washington.

Example 2 - NewStar Energy

Factoring is also used by businesses that grow so quickly they surpass the lending ability of their traditional bank. In these cases factoring companies can step in to provide the additional capital.

This example uses NewStar Energy, a small, but rapidly growing company in Virginia that has developed a solar panel solution that dramatically decreases the energy savings payback period. Home Depot has taken a serious interest in this product and has decided to put in order for 80,000 units. This amount far exceeds anything the company has produced in the past. NewStar executives are thrilled with the size of the order, but are worried about the capital needed to fill it. Filling the order would leave their cash balances at very low levels and they still have other orders coming in. The company would be in a very difficult position until they receive payment from Home Depot.

NewStar decides to approach a factoring company to help finance the fulfillment of the order. The factor sees little risk in collection from Home Depot. Therefore, the factor purchases NewStar's accounts receivable. This allows NewStar to easily fill the Home Depot order as well as the rest of their orders while maintaining a healthy cash balance.