Companies need cash flow to stay alive. Money from sales is the lifeblood of a business — stop the flow of funds and the whole enterprise quickly seizes up. In order to make sales, businesses are frequently compelled to offer their customers goods and services on credit terms in advance of payment, with sellers in effect financing their customers’ purchases at their own expense. Payment for the goods is expected to be made in 30, 60, 90 days, in six months or even a year later. Meanwhile the business offering its wares on credit must cover its own overhead, including the cost of goods sold. If financing is tight as in many a growing enterprise, this can put the seller in a quite a tight spot. Where does a company turn to raise cash?
Factoring is a way for a business to sell its accounts receivable invoices to an outside financier (a factor) at a discount in return for immediate cash. Unlike a bank loan, factoring transactions are not significantly influenced by a company’s credit rating and credit worthiness, since the transaction is essentially the resale of a business asset. In fact it is not a loan at all, but rather a sale of financial assets (receivables) to a third party.
Although the two terms are often mistakenly used synonymously, ‘ invoice discounting ‘ is a different kind of transaction. Whereas factoring is the sale of receivables, invoice discounting is lending which uses receivables as collateral.
In exchange for cash, a business transfers ownership of its receivable invoices to a factoring firm, which thereby takes on all the rights and risks which come with those receivables. The factor buys the right to collect the debtor’s payments on the full original invoice amount, but on the other hand, factoring companies also must eat any losses should the debtor neglect to pay.
If everything goes well, the selling company is able to maintain its vital cash flow for continued operations, while the factoring firm profits from the difference between what it paid for the receivable invoices, and the amount it eventually collects from the debtor.
That’s invoice factoring in a nutshell.
