Factoring is the use of a borrowing entity's accounts receivable as the basis for a financing arrangement with a lender. The borrower is willing to accept a factoring arrangement when it needs cash sooner than the payment terms under which its customers are obligated to pay. Factors are usually willing to advance funds quite rapidly under this type of arrangement.
This type of borrowing is intended to be short-term, so that borrowed funds are expected to be repaid as soon as the associated accounts receivable are paid by customers. A factoring arrangement can be extended by constantly rolling over a new set of accounts receivable; if so, a borrower can may have a base level of debt that is always present, as long as it can sustain an equivalent amount of receivables.
The fees associated with factoring can be quite high, making this one of the more expensive financing alternatives available. Consequently, borrowers typically review other types of financing arrangements before they turn to factoring as an option. Nonetheless, a startup business with no corporate history may be turned down by more traditional lenders, and so must use factoring as its main avenue to gain access to cash.
There are several variations on the factoring concept, which are:
- Lender has control. The lender advances a certain percentage of the receivable balances to the borrower, and commits to collect the receivables. The lender monitors all receivables due from the customers of the borrower, and has payments sent to the lender's designated location. This approach reduces the risk of non-payment for the lender.
- Borrower has control. Accounts receivable are essentially used as collateral on a cash advance from a lender, but the borrower maintains control over the receivables and collects from customers. This approach is least visible to customers.
From the perspective of the borrower, there is a strong incentive to keep customers from knowing about any factoring arrangements, since factoring gives the appearance of the borrower having shaky finances. However, giving the borrower control over the receivables makes it less likely that the lender can collect on the receivables in the event of a default by the borrower. Thus, there is an inherent tension between the parties regarding how a factoring arrangement is to be set up.