Invoice factoring definition
/What is Invoice Factoring?
Factoring is the use of a borrowing entity's accounts receivable as the basis for a financing arrangement with a lender. The borrower is willing to accept a factoring arrangement when it needs cash sooner than the payment terms under which its customers are obligated to pay. Factors are usually willing to advance funds quite rapidly under this type of arrangement.
Example of Invoice Factoring
Federal Factoring purchases a $5,000 invoice from Grouch Electronics, giving Grouch an 80% advance on the face value of the invoice (which is $4,000), and charges a 5% fee on the face amount (which is $250), on the assumption that payment will be received from the customer under Grouch’s normal 30-day payment terms.
Thirty days later, Federal receives the full $5,000 payment from the customer. Of this amount, Federal retains $4,000 to offset the original amount of its payment to Grouch, keeps the $250 fee, and rebates the remaining $750 to Grouch. In effect, Grouch has paid $250 in exchange for the use of $4,000 for a period of 30 days.
Duration of Invoice Factoring
This type of borrowing is intended to be short-term, so that borrowed funds are repaid as soon as the associated accounts receivable are paid by customers. A factoring arrangement can be extended by constantly rolling over a new set of accounts receivable; if so, a borrower can may have a base level of debt that is always present, as long as it can sustain an equivalent amount of receivables.
Variations on Invoice Factoring
There are several variations on the factoring concept, which are noted below. From the perspective of the borrower, there is a strong incentive to keep customers from knowing about any factoring arrangements, since factoring gives the appearance of the business having shaky finances. However, giving the borrower control over receivables makes it less likely that the lender can collect on the receivables in the event of a default by the borrower. Thus, there is an inherent tension between the parties regarding how a factoring arrangement is to be set up.
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Lender Has Control
The lender advances a certain percentage of the receivable balances to the borrower, and commits to collect the receivables. The lender monitors all receivables due from the customers of the borrower, and has payments sent to the lender's designated location. This approach reduces the risk of non-payment for the lender.
Borrower Has Control
Accounts receivable are essentially used as collateral on a cash advance from a lender, but the borrower maintains control over the receivables and collects from customers. This approach is least visible to customers.
The Cost of Factoring
The fees associated with factoring are quite high, making this one of the more expensive financing alternatives available. Consequently, borrowers typically review other types of financing arrangements before they turn to factoring as an option. Nonetheless, a startup business with no corporate history may be turned down by more traditional lenders, and so must use factoring as its main avenue to gain access to cash.