What Is the Meaning of Factoring in International Financing?
The transaction of factoring is the very simple process of selling the firm's accounts receivable in order to receive an inflow of cash that is determined by the value of the accounts receivable. This transaction allows the firm access to funds that it can use for continued investment in various projects.
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Factoring
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Factoring is when a firm decides to sell its accounts receivable in order to receive cash for investment purposes. Accounts receivable are the invoices for goods or services that a firm offered to a client. The invoice contains the sale of the goods or service, terms of payment and date of receipt of payment. In terms of accounting, accounts receivable are considered assets. A potential buyer of a firm's accounts receivable evaluates the risk involved in the purchase by evaluating the firm's past ability to collect on accounts receivable.
Rate of Return
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A firm may need to decrease its cash balances by selling its accounts receivable at a discounted value when the prospective value of return on an investment exceeds acting as a creditor for customer balances. This prospective value on an investment is known as the rate of return. The rate of return is calculated by determining the ratio of investment funds that may be gained or lost in respect to the total amount invested. There are various mathematical formulas employed to find the rate of return depending upon the situation. In all situations, the initial investment, final investment and profit loss/gain are the major inputs of the equations. A firm will rely on factoring when there is a long term decrease in the firm's cash flow and/or the firm has been carrying a cash balance for an extended period.
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International Finance
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In international finance, a firm may choose to factor for the same reasons already explained, though the factoring transaction is completed across national lines. The result is one transnational firm buying the accounts receivable of another transnational firm. The transnational firm that sold the accounts receivable receives a cash payment that it is able to use in foreign or domestic investment projects.
Reasons
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The reasons why a firm may choose factoring versus securing a loan is due to timely efficiency. The process of receiving cash after an accounts receivable sale is much faster and an easier process to facilitate than that of loan approval and disbursement. The process of factoring is not dependent upon the firm's credit, and while the sale of the accounts receivable is priced at a discounted value, it may not be as costly as a high interest rate loan.
History
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Factoring is one of the oldest business transactions that is still in practice. Tracing its roots back to Mesopotamia, factoring was used as a means to settle trade debts. The practice was picked up by the Romans and by the 1700s, it was a common practice by English settlers to resolve debts and garner finance for travels to and from America. The introduction of the credit card in the 20th century resulted in a boom in factoring transactions and has had the most significant impact on the volume of factoring transactions in the past century.
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