What Occurs When a Company Factors Its Receivables?

Receivables factoring offers businesses a way to convert outstanding invoices into immediate cash. This financial arrangement involves selling a company’s accounts receivable, which are the amounts owed by customers for goods or services already delivered, to a third party at a discount. By doing so, a business can unlock funds tied up in unpaid invoices, addressing immediate working capital needs without waiting for traditional payment terms to mature. It provides a means to access liquidity and manage cash flow more effectively.

Understanding Receivables Factoring

Receivables factoring involves selling a company’s invoices to a specialized financial institution, known as a factor, at a reduced price. This allows the selling company to receive cash promptly, avoiding long waits for customer payments, which can extend to 90 days or more. The factor then assumes the right to collect on these invoices.

Three parties are involved in a factoring arrangement. The company, or seller, generates invoices by providing goods or services to its customers. The customer, or debtor, owes money for these goods or services. The factor is the financial entity that purchases the invoices and collects payments directly from the customer. The factor’s profit comes from the difference between the invoice’s face value and the discounted price paid to the seller.

The Step-by-Step Factoring Process

The factoring process begins when a company issues invoices to its customers for goods or services provided. The company then submits these invoices to a factoring company for evaluation and approval. The factor conducts due diligence, verifying invoice validity and assessing customer creditworthiness.

Once invoices are approved, the factoring company provides an initial cash advance to the selling company. This advance represents a portion of the invoice’s face value, typically 70% to 90%. The remaining percentage, known as the reserve, is held by the factor until the full invoice amount is collected from the customer.

Following the advance, the factor assumes responsibility for collecting payment directly from the customer. The factor often notifies the customer that the invoice has been sold, directing payment to them. After the customer pays the full invoice amount, the factor remits the reserve amount to the selling company, minus factoring fees and charges.

Financial Statement Impact

Factoring transactions directly influence a company’s financial statements, reflecting the conversion of accounts receivable into cash. On the balance sheet, the primary change involves a reduction in accounts receivable as these assets are sold, and a corresponding increase in the cash balance. This shift improves liquidity and can present a more robust current asset position, as the receivables are derecognized from the balance sheet.

On the income statement, the fees charged by the factoring company are recognized as an expense. These factoring fees reduce the company’s net income for the period. While these fees impact profitability, they represent the cost of accelerating cash flow.

For the cash flow statement, cash received from factoring is classified as an operating activity cash inflow. This is because factoring converts an operational asset (accounts receivable) into cash, supporting day-to-day operations. This immediate infusion of cash helps a business meet financial obligations, such as payroll or supplier payments.

Key Considerations for Factoring

When evaluating factoring arrangements, companies encounter different structures that define how risk and communication are managed. Recourse factoring is a common type where the selling company retains the risk of customer non-payment. If a customer fails to pay the invoice, the selling company is obligated to repurchase the invoice or replace it with another. Conversely, non-recourse factoring transfers the risk of customer non-payment to the factor, meaning the factor absorbs the loss if the customer does not pay, though this typically comes with higher fees.

Factoring fees are structured as a percentage of the invoice’s face value. These fees, often called discount rates, can be flat or tiered, with rates potentially increasing the longer an invoice remains outstanding. Typical factoring rates can range from 1% to 5% of the invoice value, influenced by factors such as industry, invoice volume, and the creditworthiness of the customer.

Another structural element is whether the customer is informed of the factoring arrangement. In notification factoring, customers are explicitly notified that their invoices have been sold and are instructed to make payments directly to the factor. In contrast, non-notification factoring, also known as blind factoring, means the customer is not informed of the factoring arrangement. In this scenario, the selling company continues to collect payments from the customer and then forwards those payments to the factor, maintaining the appearance of direct dealings.