In its narrowest interpretation, factoring is a commercial product where a business entity known as a 'factor', purchases accounts receivable from any other business or commercial enterprise at a discount, and pays for these accounts receivable with immediate money. However factoring has come a long way since its original concept and today factoring is a vehicle which enables a business to raise quick money for working capital or to fund any other activity. Factoring is a useful financing product which is suited to the commercial needs of both big and small business but should not be confused with a bank loan from which it differs in several ways.
Factoring as a commercial practice has been in use for over 4,000 years. It is very common-place in Europe and many other parts of the world, and is fast becoming the preferred way of doing business in the United States. Factoring was widely practiced in the early part of the century in the United States, but largely restricted to the garment and textile trades. Interestingly, factoring played a role in American commerce in the days of the colonists, before the Revolution. European merchants would import raw materials like wool, timber, furs and cotton from merchants in the colonies. In those days of sailing ships, considerable time would elapse from when an American merchant shipped out his goods to the time he received payment. The delay would leave the merchant strapped for working capital. To circumvent this problem and to ensure smooth and uninterrupted trade, British and European merchants started making part payments to their American suppliers in anticipation of goods to come – a variation of factoring. This ensured that American merchants had enough working capital to continue purchasing and sourcing supplies without any hitches.
Businessmen began to appreciate the benefits of factoring from the 1960s onward when banks were becoming more regulated. Businesses began finding it increasingly difficult to get traditional financing which made factoring of accounts receivable the preferred way of funding and obtaining timely and adequate working capital. Factoring had another advantage – it looked at the credit worthiness of the customer that had to pay, rather than the business that raised the invoice. This did away with delays and possible refusals arising from necessary credit checks. Additionally, a factor purchased a company's outstanding invoices for which they charged a fee. This meant the original company was unaffected by rising interest charges. Factoring transactions are currently estimated at $70 billion per year in the United States.
Today there are various facets to commercial factoring. The most commonplace is Accounts Receivable Factoring. In this case, a company sells its invoices to a factor for an amount that is less than the face value of the invoices by an amount mutually agreed to for discount and reserve. The reserve is essentially the factor's safeguard against short payment. This could be due to delayed payment by the debtor or payment of less than the face value of the invoice. The transaction is completed with the factor making two payments to the seller – the first on purchasing the invoice from the seller, and the second on receiving the full value of the invoice, on time, from the debtor. On occasions, the payment terms might be spread over intervals. In such transactions, the factoring company might make a series of pro rata payments to the seller whenever the debtor pays an installment. Since the factoring company is the owner of the invoice/s, it assumes the responsibility for pursuing payment from the debtor.
One significant point is that factoring is different than a bank loan. Factoring is driven by the value of the financial asset, in this case the invoice/s value, where a company's credit worthiness plays a minimal role. Factoring is also a commercial transaction where a financial asset has been purchased, unlike a bank which extends a loan.
Factoring is also applied to other facets of business like international trade where funding is done through international factoring. In these transactions, two factors are involved – the import and export factors – both of whom are members of international trade organizations. International factoring is used by almost all nations on the planet.
Other forms of financing that are related to factoring are Inventory Financing, Purchase Order Financing and Merchant Cash Advances. In fact there is no area of commercial financing where factoring cannot play a role. An additional advantage is that most factoring companies are flexible to new proposals and, unlike a bank, make quick, time-driven decisions.