What Is Accounts Receivable Factoring and How Does It Work?

Accounts receivable factoring companies provide funds against a business's outstanding receivables. Factoring is most often structured as a purchase and sale transaction, where the trading company sells an asset-based financial amount to a so-called factoring company or factor company. The trading company's ownership of the outstanding receivables is legally transferred to the factoring company.

The sale is usually agreed upon at a discounted price compared to the nominal receivables book value recorded in the financial statements of the trading company. The operating company that sells the asset receives immediate cash proceeds.

The sale transaction takes place at a discount to the nominal receivable value recorded in the trading company's financial books. The trading company that sells the receivable receives immediate payment. This immediate payment is only part of the agreed total value of the receivable. The invoice discounter will make further payments as the receivables are collected.

The price that an invoice discounter pays for a company's outstanding receivables depends on a number of factors, including the average size of the debtor's outstanding invoices, the number of customer debtors, the creditworthiness of the debtor, the average length of the collection period, and the average age of the outstanding invoices (the longer the debt, the lower the price the invoice discounter will pay.

Banks have very different lending criteria compared to factoring companies. Banks' lending decisions are primarily based on creditworthiness, financial history, cash flow, and collateral. Small and medium-sized companies that have just started business, have few assets, weak balance sheets, or have had financial problems in the past will have difficulty getting loans from banks.

The risk of default by the debtor is also an important issue. Some factoring companies are flexible in dealing with this issue and can structure the transaction in two ways depending on the company's preference. These two methods are known as non-recourse factoring and no-appeal factoring.

In non-recourse factoring, the factoring company accepts the non-payment risk and agrees that there will be no recourse to the company if the default experience is worse than expected. No-appeal factoring is the opposite, with the company accepting the non-payment risk. Naturally, if the factoring company accepts the default risk, the price it offers for the receivables will be lower.