Factoring

Definition

Factoring is a financial transaction where a business sells its accounts receivable to a third party (called a factor) at a discount. This provides the business with immediate cash flow and transfers the risk of collecting the receivables to the factor.

5 Must Know Facts For Your Next Test

1. Factoring helps businesses improve their working capital by providing immediate funds from outstanding invoices.
2. The factor charges a fee for their services, which includes evaluating credit risk and collecting payments.
3. Factoring can be either recourse or non-recourse; in recourse factoring, the business must buy back any uncollected receivables.
4. This financing method is particularly useful for businesses with long payment cycles who need steady cash flow for operations.
5. While factoring improves liquidity, it may be more expensive than traditional financing methods due to higher fees.

Review Questions

• What is the primary benefit of factoring for a business?
• How does recourse factoring differ from non-recourse factoring?
• Why might businesses prefer factoring over traditional loans?

Related terms

Accounts Receivable: Money owed to a company by its customers for goods or services delivered on credit.

Working Capital: The difference between current assets and current liabilities, indicating short-term financial health.

Trade Credit: An arrangement where suppliers allow buyers to purchase goods or services on account, deferring payment until later.