What Is Factoring and How Does It Work?

Factoring is a financial service where a business sells its accounts receivable, or unpaid invoices, to a third party at a discount to receive immediate cash. This practice allows companies to convert their outstanding invoices into liquid assets, addressing cash flow gaps that arise from customers taking time to pay.

The Core Concept of Factoring

Factoring involves a business selling its invoices to a specialized financial institution, known as a factor, at a discount. This transaction transforms accounts receivable into immediate working capital. Businesses often use this method to improve their cash flow, enabling them to cover operational expenses, manage payroll, or invest in growth opportunities without waiting for standard payment terms of 30, 60, or even 90 days.

Three main parties are involved in a factoring arrangement: the client (the business selling invoices), the factor (the financial institution purchasing invoices), and the debtor (the client’s customer who owes the money).

Factoring differs from traditional loans in that it is a sale of an asset, not a debt. This distinction means factoring does not typically appear as debt on a company’s balance sheet, which can be advantageous for maintaining a healthy debt-to-equity ratio.

How Factoring Transactions Work

The factoring process begins when a business issues an invoice. To accelerate cash flow, the business submits the invoice to a factor for verification.

The factor performs due diligence, assessing the customer’s creditworthiness and verifying the invoice’s legitimacy. After verification, the factor provides an initial advance to the business, typically ranging from 70% to 95% of the invoice’s total value. The remaining portion of the invoice value is held in a reserve account by the factor.

After the advance is disbursed, the factoring company assumes responsibility for collecting the payment directly from the customer. In many cases, the customer is notified that their invoice has been sold to the factor, and future payments should be directed to the factor. Once the customer pays the full invoice amount to the factor, the factor releases the remaining balance from the reserve to the original business, deducting its factoring fees.

Common Types of Factoring

Factoring arrangements can vary, primarily by who bears the risk of non-payment by the debtor. Recourse factoring is common: the business that sold the invoice remains responsible if its customer fails to pay. If the debtor defaults, the original business must buy back the unpaid invoice or provide a replacement invoice.

Non-recourse factoring, in contrast, shifts the majority of the risk of non-payment to the factoring company. If a customer becomes insolvent and cannot pay the invoice for credit-related reasons, the factoring company typically absorbs that loss, and the original business is not held liable. While this offers greater protection against bad debt, non-recourse factoring generally comes with higher fees due to the increased risk assumed by the factor.

Other factoring variations exist. Spot factoring allows a business to sell a single invoice or a select group of invoices as needed, offering flexibility without a long-term commitment. Whole ledger factoring involves an ongoing agreement where a business sells all or a significant portion of its accounts receivable to the factor. Full-service factoring expands on this by including comprehensive services such as managing sales ledgers, providing collection services, and handling credit control, in addition to financing invoices.

Costs and Considerations

The primary cost is the “factoring fee” or “discount rate,” which is a percentage of the invoice’s face value that the factor charges for its services. This fee typically ranges from 0.5% to 5% per invoice, although rates can sometimes go as high as 10% depending on factors like invoice volume, customer creditworthiness, and the industry.

Beyond the primary factoring fee, businesses may encounter additional charges. These can include application fees, setup fees, credit check fees, wire transfer fees, or penalties for disputed invoices. Some agreements might also include termination fees if a business decides to end the factoring arrangement prematurely.

Factors conduct due diligence, evaluating the selling business and, more importantly, the creditworthiness of its customers. The factoring arrangement can also impact customer relationships, as the factor often takes over the collection process, communicating directly with the debtors regarding payment. Businesses should review how the factor intends to interact with their customers to ensure it aligns with their customer service standards.