A company uses a factoring arrangement to obtain immediate cash financing in exchange for giving up control over its accounts receivable to a finance company. In essence, the arrangement requires customers to send their remittances to a lockbox that is controlled by the finance company. In addition, the finance company takes on the risk of loss from any bad debts incurred, though it may choose to pick only selected receivables in an effort to reduce the potential amount of bad debts. A factoring arrangement is most agreeable to a finance company when the average receivable is large, since this means that the collection cost per receivable is reduced.
If the borrower can only provide smaller-size receivables, the finance company may charge an extra fee that reflects its collection costs.
The primary profit to the finance company comes from the interest rate charged on the arrangement, which is quite high in comparison to the prime rate. The lender may also charge a minimum total fee that reflects the recovery of its loan origination costs. The net cost to the borrower is reduced somewhat because it is no longer involved in the collection of receivables, since that chore has been taken over by the finance company.
The borrowing entity can reduce its costs under the factoring arrangement by electing to be paid somewhat later. However, companies usually only enter into these arrangements if they have an immediate need for cash, so the interest cost tends to be maximized.
A variation on the factoring concept is accounts receivable financing, where the lender treats accounts receivable as collateral for a loan, rather than taking over ownership of the receivables. The lender still takes payment directly from customers, but is choosier is allowing only recent receivables to be classified as collateral. A common arrangement is to limit the size of the loan to 80% of those receivables that are less than 90 days old. Also, if the collateral balance drops below the loan amount, the borrower must pay back the difference at once.
Both factoring and accounts receivable financing are considered expensive sources of funds, and so are not recommended until more traditional (and less expensive) forms of financing have been explored. The concept is most applicable to short-term financing situations where a company is growing rapidly and has a large enough gross margin to support the high interest rates. Once growth begins to plateau, the borrower then transitions toward more traditional forms of financing.