What Is Factoring in Finance?
Factoring is a way for companies to both manage receivables and working capital. The transaction also allows for less variability in cash flows, which is always a good idea when trying to manage earnings. By selling accounts receivables to a 3rd party (the factor), a company can free up cash for purchases of inventory while de-levering the balance sheet. After all, a receivable is only a promise to repay funds.
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History
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Factoring was first introduced as a solution to international trade and has been in use since before the 1400s. With the advent of more robust trading systems, factoring, or receivables financing, has also evolved. Changes in common law also spurred its use as early laws required a debtor be notified before selling the debt. In 1949, the United States decreed that the debtor did not need to be notified, which greatly increased the popularity of factoring solutions.
Significance
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At its core, factoring is a way for companies to pull cash from their balance sheet. Receivables are looked at as legal short-term debt obligations. Selling them not only provides cash, but it reduces current liabilities, making the balance sheet look more attractive to lenders. It is also used as a way to finance working capital, such as inventory, and to balance out the variability in seasonal cash flows.
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Considerations
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Like most financial products, there are risks associated with factoring. The main one is counter-party risk, which is the risk related to doing business with another party. Bank acceptances and other short-term insurance products are available to mitigate this risk. Another risk is fraud which can manifest as fake invoices or insurance. Legal concerns are also numerous for international trade as different countries have different compliance laws related to data exchange and privacy.
Types
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The most common form of factoring is "without recourse;" that is, all the risk associated with the arrangement rests on the company purchasing the receivables. They have no recourse in putting the receivables back to the originator. Smaller companies may only be able to sell receivables with recourse, which allows the buyer of receivables to sell those receivables not claimed, back. Usually, the time period for recourse arrangements is 60 to 90 days.
Not a Bank Loan
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One of the most important concepts to understand about factoring is that it is not a loan, though banks are usually buying or acting as intermediary in the transaction. The main difference is on the counter-party. For a loan, the risk of default on payment is with the obligor or the seller of the receivables. In contrast, factoring places the risk on the holders of the receivables. The seller of the receivables has effectively already underwritten the deal. The reputation of the seller is still a consideration; however, the creditworthiness of the actual receivables is the real concern. A company with poor revenue recognition policies might also be a poor borrower.
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