What is a factor?
A factor is an intermediary agent who finances the receivables. A factor is essentially a source of funding that agrees to pay the company the value of an invoice minus a discount on commissions and fees.
The factor immediately advances the major part of the amount invoiced to the company and the balance upon receipt of the funds from the invoiced part. There are three parties directly involved in a transaction involving a factor: the factor, who buys the debt; the seller of the debt; and the debtor, who must make a payment to the owner of the invoice.
How a factor works
A factor allows a business to obtain immediate capital based on future income attributed to a particular amount owed on a debtor account or a business invoice. Accounts receivable (AR) act as a record of the money customers owe for sales made on credit. Factoring allows other interested parties to purchase the funds due at a reduced price in exchange for an initial cash payment.
The terms and conditions set by a factor may vary depending on their internal practices. Most often, factoring is done through third-party financial institutions, called factors. Mail carriers often unblock funds associated with newly purchased customer accounts within 24 hours. The reimbursement conditions may vary depending on the amount concerned. In addition, the percentage of funds provided for individual customer accounts, called the advance rate, may also vary.
Factoring is not considered a loan because the parties neither issue nor acquire debt in connection with the transaction. The funds provided to the company in exchange for accounts receivable are also not subject to any restrictions on use.
Example of factoring
Suppose a postman agreed to purchase a $ 1 million invoice from Clothing Manufacturers Inc., representing the outstanding debts of Behemoth Co. The postman negotiates to discount the bill by 4% and will advance $ 720,000 to Manufacturers from Apparel Inc. The balance of $ 240,000 will be forwarded by the factor to Clothing Manufacturers Inc. upon receipt of the invoice for $ 1 million from accounts receivable from Behemoth Co. The factor’s fees and commissions for this factoring agreement amount to $ 40,000.
The factor is more concerned with the creditworthiness of the invoiced party, Behemoth Co., rather than the company from which it purchased the receivables. Although factoring is a relatively expensive form of financing, factors provide a valuable service to businesses operating in sectors where it takes time to convert debts to cash and to rapidly growing businesses in need of liquidity. to take advantage of new business opportunities.
Key points to remember
- A factor is essentially a source of funding that agrees to pay the company the value of an invoice minus a discount on commissions and fees.
- The terms and conditions set by a factor may vary depending on their internal practices.
- The factor is more concerned with the creditworthiness of the invoiced party, Behemoth Co., rather than the company from which it purchased the receivables.