When a business engages in accounts receivable factoring, it sells its receivables or invoices owed to it by its customers at a slightly lower price so that it can collect the cash today. They are paid immediately by the buyer and thus do not have to wait for their customer to pay them 30, 60, 90 or more days later. Not a bad gig is it?

In a factoring transaction, a small business may decide to sell the invoice (what it is owed) to a factoring company (also called a \”Factor\”) in order to collect the cash today instead of waiting to get paid X number of days out. Invoice factoring has broad implications, and I have seen it applied to instruments of all kinds. For example, when someone is awarded a structured settlement by the court resulting from an injury claim, the recipient typically gets a small amount of payment for X number of months or years. But what if the recipient wants all the cash today?

Similarly, when one wins a lottery, they are given the option of collecting over a period of months and years, or a lump sum payment today. The latter option is essentially a factoring transaction because it expedites the cash collection. Why would someone take a smaller cash amount today than a larger cumulative income stream over the years? There are several reasons. The individual may have debts to pay off such as a mortgage. The individual may need seed capital to start a business. Or, as it applies to this article, a small business owner may need the cash today to sustain adequate working capital levels or expand the business. The reasons are countless to say the least.

Like anything else in life aside from fresh air, factoring comes with its costs. There are costs involved in setting up a relationship with a Factor because the Factor has to expend time and resources conducting due diligence over a small business and the quality of its receivables / invoices. In addition to the set up fee, each factoring transaction involves a discount fee or a \”haircut\” as commonly referred to in the industry. This haircut is essentially the fee charged by the Factor for fronting up the cash.

These fees can range from 1-5%. However they are mostly in the 3% ballpark. So when a business decides it needs the cash today to expand operations or to pay employees, factoring is a quick way to raise the cash needed immediately.

Some businesses may not need the money but still decide to factor their invoices. This is because it saves them the time needed to collect in house. By factoring invoices out, a business can save on some salary expenses. The 3% fee may come out cheaper at the end of the day.

In conclusion, receivables factoring is fundamentally no different than securitization transactions that take place at larger financial institutions. I hope to have provided a broad yet complete enough overview to a new concept that may help you or someone you know run their business more effectively and efficiently.

Still fuzzy about this concept? Read the accounts receivable factoring guide here. To read more about the comparison between factoring and securitization, read Curt Matsen, CPA\’s article accounts receivable factoring services and securitization.

Accounts Receivable Factoring – A Quick Way to Raise Cash is a post from: Finance Marketing Business