• 13Dec

    What is factoring in finance?

    Factoring basics

    To understand factoring, it is important to know about account receivables. Account receivables (or debtors) refer to the money owed by customers to the company. Factoring is the sale of account receivables to a third party usually at a discount. The process of factoring involves three parties: the debtor, the seller, and the factor. The debtor is the customer who owes the money (in lieu of some services) to the company, the seller is the company, and the buyer of account receivables is the factor. Receivables can be financial assets or cash or other form of liability which the debtor owes to the seller usually in return of some products or services. Factoring organizations are mainly the buyers of such receivables. The primary reason for selling the account receivables can be two fold: first, the seller maybe in immediate need of liquid cash, and second, the seller might be finding it difficult to get the dues from debtors. In both the circumstances, the factoring entities enable the seller to divest the liability in return of cash. In accounting terms, the sale of receivables transfers the ownership of receivables to the factor. In the future, whenever the debtors’ pay back the debt, the amount goes to the factor. 

    Why is factoring beneficial?

    The prime reason for factoring is to obtain cash. If a company is facing a cash crunch, selling the account receivables (maybe in form of invoices or other sales notes) is one of the methods to get cash by selling them to a factoring entity. While some companies do factoring only in case of a cash crunch, there are others which utilize factoring as a method of financing. They take into account the concept of ‘time value of money,’ i.e., a dollar is worth more, as compared to a dollar next year. Thus it helps to get cash on hand today, rather than keeping receivables in the account books for substantial periods of time. The cash balance achieved through factoring can then be utilized in more productive aspects, for example – in building capital assets or enhancing the production capacity of company or ramping up the sales team. Factoring not only provides immediate cash but also reduces a lot of back-office work related to follow-up with debtors regarding payments. By selling the receivables, the company gets rid of many problems.

    Factoring in finance

    The prime reason for factoring is to obtain cash.

    History of factoring

    The origin of factoring relates to merchant banking activities in England. The first users of factoring were merchants who had diverse business interests spanning geographic borders. Many centuries back, modern communication media were not present. Thus, it made sense for a far-off merchant to sell the receivables to a local factor, who would be more suited to get the receivables. This involved some discount in sale since the buyer, i.e., the factor, would have to share the risk of unpaid receivables.

    Earlier the notification of the debtor regarding the transfer of receivables was mandatory in England, but later on, as the laws evolved, the notification process became obsolete. Thus a receivable could be transferred to a third-party buyer without knowledge of debtors. The industrial revolution in England saw even more development in the use of factoring for the purposes as described previously.  It became an easy method of accessing working capital. This was even more important since the banking system was evolving parallel to the industry changes during these centuries. Over the centuries, this practice of factoring became one of the accounting practices and also one of the modes to have liquid cash to fund growth.

     In the 20th century, with the advent of information communication technologies and the Internet, it became easier for the sellers and factors to sign these factoring agreements. It has not only reduced the costs for the company but also expedited the process of collecting receivables. In current times, factoring has been accepted as a good financial and accounting practice as a possible avenue to fund growth through access to cash.

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