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What is factoring?

Factoring is the sale of commercial accounts receivable invoices to a buyer, or factor, at a discount, in order to obtain cash on the invoices, with the factor assuming full responsibility for credit analysis, payment collection and credit losses on the new accounts. There are usually three parties involved when an invoice is factored: the seller of the product or service who originates the invoice, the debtor is the recipient of the invoice for services rendered who promises to pay the balance within the agreed payment terms, and the factor.

The accounts receivable and the responsibility for the collection are sold rather than provided as loan collateral, and the client must notify all of its customers of the new arrangement. This can involve a very substantial payment being made right at the start, with most factors paying 70% to 90% through initial advance of the invoice amount followed by a small additional payment, through reserve release, once they collect the invoice. Over the course of time, factors may offer the liable individual or entity a discount from 2% to 5% or more on the outstanding debt.

Factors advance funds under one of two conditions: non-recourse, where the factor assumes all the liability for the invoice, this costs quite a bit extra but can be advantageous, with insurance typically covering 80% of a debt rather than the whole thing, or recourse, where the factor can come back to the business should the invoice become uncollectible and require reimbursement. Even though some factors buy the invoices from a company, their contracts are very specific that if an invoice is not paid within a certain period of time, usually 30 to 90 days, the factor will reclaim any advances it has made against the invoice. Factoring is designed to be more beneficial to the seller of the account than to the debtor. The seller receives money, while the buyer makes a profit by buying the account for less than what it was valued at and then collecting on it.

Factoring allows a buyer to purchase these accounts for around 25% less than what they are actually worth. Setting up a factoring deal can be done more quickly than most other forms of finance.The staff at factoring companies are more commercial than at other lending institutions, and will work to find a solution for potential client companies. There are some possible disadvantages, the main ones being cost and the fact that clients have to deal with the factoring companies.

Factoring can also be a gamble for the factor, because there may be bad debts or other obstacles to collecting the funds. Therefore, factors have begun running credit checks and assessing the financial health of potential clients before entering into a factoring arrangement. Clients provide annual reports and other indicators of financial health to factors before they are approved. Factors often establish a credit line with clients and dictate the amount of credit that their clients can offer to customers.

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