Definition of Debt Factoring

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Close-up of calculator over data chart (Image: a-wrangler/iStock/Getty Images)

Debt factoring, also known as invoice factoring or accounts receivable financing, refers to the practice of selling a business's unpaid invoices to an external entity. This may be an important financing tool for a company that cannot meet short-term obligations due to non-payment from customers.

How It Works

When a business sells its accounts receivables to a factor, it does so at a discount. Suppose that a window-washing company determines that its unpaid invoices for a certain period are $15,000. Due to insufficient funds caused by customer non-payments, the company is not able to satisfy its obligations, or invest in a larger office. In order to recover the debt quickly, the company may sell its invoices to a factor for a discount. The factoring company may pay $14,300 to the window-washing company before attempting to recover the funds from the window-washer's customers. In this situation, the window-washer benefits from recovering its debts sooner and improving its cash cycle, and the factoring company makes a profit from the difference, $700.

Factoring Payments

The debt factoring arrangement is a necessary and frequently-used tool for many companies. Under such agreements, the factor pays a percentage of the agreed-upon price when the debts are sold, and pays the remaining amount when the factor recovers all the debts from the company's customers. In the previous example, the factor may pay $12,870 -- 90 percent of the agreed-upon price of $14,300 -- up front, and then the balance of $1,430 upon full debt recovery.

Evaluating the Business

A factoring company evaluates a company before going into an arrangement. When a business approaches a factor to sell its debts, the factor will analyze the business's performance, its relationship with its customers, and size of the debt. This information gives the factor an overall idea of the the company and the collectibility of its receivables.

Factoring Types

Factoring agreements are either recourse agreements or non-recourse agreements. In a recourse factoring agreement, the factoring company does not bear the burden of the company's bad debts; terms in the agreement generally state when debts should be considered non-collectible and the procedures to repay the factor. On the other hand, in non-recourse debt factoring agreements, the factor assumes the risk of non-collectible and bad debts. This means that the factoring company has no recourse against the company that sold the debts.

Disadvantages

Even though factoring may improve a business's cash cycle, many companies prefer not to employ such tools. The cost of factoring may be significant for many businesses, because the cost of capital is higher than other sources of financing, such as bank loans. Over time, factors may also have an influence on a company's customer base, preferring to deal with certain customers and influencing the company to let go of others. Another disadvantage is that an unprofessional factor may harm a customer's view of the company when it coerces the customer to pay.

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