Factoring is a financial service where a business sells its accounts receivable to a third-party financial company, known as a factor, at a discount. The factor then takes over the responsibility of collecting the outstanding payments from the customers of the business. Factoring helps businesses to convert their credit sales into immediate cash, thereby improving their cash flow and working capital.
Factoring is different from traditional bank lending because it is based on the creditworthiness of a business’s customers, rather than on the creditworthiness of the business itself. This means that businesses with poor credit ratings or limited collateral can still use factoring as a financing option.
Factoring is also different from invoice discounting, another form of receivables finance, in that factoring involves the outright purchase of the accounts receivable, whereas invoice discounting involves borrowing against the accounts receivable.
Factoring can be categorized into two types: recourse and non-recourse factoring. In recourse factoring, the business remains liable for any unpaid debts and assumes the credit risk if the customer defaults on payment. In non-recourse factoring, the factor assumes the credit risk and is responsible for any unpaid debts.
Factoring is commonly used in industries such as textiles, garments, transportation, and manufacturing, where businesses have long credit periods, and the need for cash is immediate. Factoring is also used by small and medium-sized enterprises (SMEs) to improve their cash flow and working capital, allowing them to invest in growth and expansion.