What is Accounts Receivable Factoring?
Accounts Receivable Factoring, popularly known as Factoring is a financial instrument used by business for raising quick money by selling their accounts receivable to another specialized company known as “Factor”. It is also known by the name of Invoice Factoring.
How Accounts Receivables Factoring Works?
Usually Business sells goods and services to its customers either in cash or on credit. In case of credit, the Business sends an Invoice to the customers which is typically paid back to the business as per terms of credit (varies for business to business and time period range from 7 days to 180 days and even more). Instead of waiting for the customer to make payment on due dates (Duration of credit terms), a business can sell its accounts receivables at a discount from their Face Value (Invoice Value) to the specialized company known as “Factor” and receive cash immediately.
Under Invoice Factoring the discount (factor fees) charged by these companies depends on multiple factors namely:
- Due date of Receivable (Longer time frame will require more factor fees compared to a shorter time frame).
- The industry that the business belongs.
- The creditworthiness of Business Credit Customers.
- Collection history of the business on its receivables.
- Amount of Invoice Factoring assigned for factoring.
- Type of Factoring-Recourse or Non-Recourse (Discussed in detail below). Non-recourse factoring required the Factor to take additional credit risk arising from uncollectible accounts receivables and hence leads to more factor fees.
- Provides immediate cash flow to Business.
- Helps business to focus on rendering value services as payment collection hassle is taken care by Factor in return for the Factor fees.
- Provides a source of funding for business with low (or no) credit history as Invoice Factoring companies discount invoices based on the credit history of the Customer and not the business.
- In case of Non Recourse Factoring (discussed in detail below) the business is a guard from losses if any arising of Bad Debts (Uncollectible Accounts Receivable).
Types of Accounts Receivable Factoring
Let’s discuss the types.
#1 – Recourse Factoring
Under this Invoice Factoring arrangement, only early payment of invoices is provided by the accounts receivables factoring companies in return for Factor Fees to the business. In case any bad debt arises at a later date due to nonpayment of dues by the Customer resulting in a loss, the business will make it good for the accounts receivables factoring companies. In other words, the credit risk remains with the original business, and in the unlikely event of any loss arises business will make good any loss to the factor. Under this, the whole debt collection process is taken care of by the business itself, and factor is paid Factor fees (which is basically the interest for advancing money against invoice to the business from the date the advance was made to the date the business gives the factor the money).
The same can be explained by the equation:
Let’s understand the same as an accounts receivables factoring example:
Company A sends Rs 10000 invoice to its customers to be paid in six months and a copy to its Factor, M/s X in return for the sum of Rs 8500. On due date (i.e. after six months) customer pays the money and Company A sends Rs 10000 to M/s X.M/s X charged 10% factor fees for the amount advanced by it to Company A and return the balance amount to Company A.
- The amount advanced by M/s X to Company A: Rs 8500
- Interest Accrued (Factor Fees): 10% of Rs 8500=Rs 850
- Invoice amount received: Rs 10000
- Accordingly, [10000-(8500+850)]=Rs 650
- Thus Rs 650 will be paid back by M/s X (Factor) to Company A after deducting factor fees to settle up the transaction with Company A.
Journal entry to record the same in the books of Company A will be:
#2 – Non Recourse Factoring
Under this arrangement, a business sells its invoices to the factor and receives cash payment immediately. The factor takes all responsibility for analyzing the creditworthiness of the customer, collection of payment on the due date and also and credit loss arising on account of nonpayment by the customer (credit risk is transferred from the business to the accounts receivables factoring companies).
As evident from the above, Non-recourse factoring involves more risk and administrative cost for the factor and is usually more expensive compared to a Recourse Factoring for the business who utilizes the services of Non-recourse factoring.
Let’s understand the same as factoring of accounts receivable example:
Company A sends Rs 10000 invoice to its customers to be paid in six months and a copy to its Factor, M/s X in return for the sum of Rs 8500. On due date (i.e. after six months), M/s X collects the same from the customer.
Accounts Receivable Factoring is a higher-cost source of funds and is used more by smaller firms that do not have a particularly strong credit history. There are other motivations also behind opting for this financial instrument tool as it helps business to focus on growing business and serving more clients rather than focusing on payment collection hassle, improve cash conversion cycle, removes credit risk to name a few. However, it is important to mention that at times (particularly in case of Non-recourse Factoring), the factor may put extra pressure on the business customer for payment and this could have a negative effect on the firms future business prospect with these customers.
Accounts Receivables Factoring Video
This has been a guide to what is Accounts Receivable Factoring. Here we discuss how accounts receivables factoring works along with its types, examples, and benefits. You may also have a look at these articles to learn more about Accounting –