Business invoice factoring is a financial transaction in which a business sells its accounts receivable at a discount to a third party for the purpose of obtaining cash or working capital to run the their business. Factoring of invoices is often necessary for even the most profitable companies, as the timing of cash inflows and outflows is not always ideal.
There are three parties to a Factoring relationship:
The entity seeking to obtain financing by selling its accounts receivable (invoices) to the Factor. In a traditional borrowing/lending relationship the Client would be seen as the “borrower.” In a Factoring relationship, the Client actually sells the invoice to the Factor rather than simply pledging the asset as it would in the traditional loan relationship.
The invoice factoring company willing to purchase the invoices at a discount. In a traditional borrowing/lending relationship, the Factor could be seen as the “lender.” In the case of factoring, the Factor purchases the invoices becoming the owner of the asset rather than a lender.
Is the entity which purchased the product or service from the Client and will be paying the invoice to the Factor. In a traditional borrowing/lending relationship this party would not exist except as a customer of the client.
The Factor purchases the invoice from the Client advancing, most frequently, 80% of the face amount of the invoice. The 20% is held in an account referred to as the Reserve. The Factor together with the Client, notifies the Debtor that when the Invoice comes due, generally in 30 days, the Debtor must make payment to the Factor as the owner of the Invoice. When the Debtor pays the Factor, the Factor takes the required fees from the Reserve and returns the remaining Reserve to the Client.
When the Debtor pays the Factor, the Factor takes the required fees from the Reserve and returns the remaining Reserve to the Client. Factoring thus provides an alternate way for companies to utilize their working assets, Invoices, to obtain working capital when they cannot qualify for traditional financing.
The Factor will also provide credit, accounting and collection services to the Client. The Factor can assist the Client in making sound credit decisions regarding Debtors. In addition, the Factor generally will provide reports on Invoices purchased, collections received, the age of Invoices purchased by the Factor, as well as transactions in the Reserve. Because this type of bookkeeping is provided, the Client is free focus on growing the business.