Factoring

Accounts Receivable Financing

Paid invoices
Factoring turns unpaid customer bills into cash. David Gould/Photographer's Choice RF/Getty Images

Traditional factoring is a business financing option in which firms raise cash by selling their accounts receivable at a discount from face value. The receivables then become the property of the buyer, who assumes the risk of delayed payment or nonpayment. Factors are individuals or firms who specialize in buying receivables.

However, most modern factoring transactions actually are structured to be more like short-term loans, with receivables pledged as collateral.

Under this scenario, the firm pledging the receivables in return for funding still retains the risk associated with uncollectible receivables.

What Are Accounts Receivable? 

Businesses often make sales of goods and services before collecting cash from their customers. When this occurs, the amounts owed but not yet paid by customers represent accounts receivable, an asset on the seller's balance sheet. Additionally, refunds or rebates owed to a business by its suppliers, but not yet paid in cash, also will be included among accounts receivable.

Accounts receivable often represent a significant portion of a firm's working capital. Many businesses use invoice discounting as a device to encourage prompt payment of bills by their customers, thereby reducing the need to raise cash either through traditional factoring at even deeper discounts, or by costly borrowing (including borrowing in a modern factoring transaction, as described below).

Yet another contemporary variation on factoring is called purchase order financing.

Factoring Terms and Conditions:

In a typical modern factoring transaction, the borrower receives an upfront cash payment equal to about 80% of the face value of the receivables pledged as collateral. When the receivables are collected in full by the factoring firm, the borrower gets paid the other 20%, minus a fee.

Fees of about 3% per month (which is the equivalent of 43% per annum) are not uncommon, making factoring an expensive way to raise cash, but a necessity for companies that cannot secure a bank line of credit on reasonable terms.

Factoring Franchises:

Two companies offer franchising opportunities for individual entrepreneurs who seek to open up their own factoring businesses. These are:

  • Interface Financial Group of Irvine, CA
  • Liquid Capital of Toronto, ONT

Successful factoring franchisees tend to be former executives, especially those who can add value for their clients by offering timely business advice. Necessary startup capital easily can exceed $300,000 for a combination of franchise fees, setup costs and seed capital for initial purchases of receivables. Finding clients and building an adequate book of business can take months, even a year or more.