Accounts Receivable Factoring Definition Examples

Accounts Receivable Factoring Definition

Accounts Receivable Factoring is a process of raising capital in which the businesses sell their accounts receivable to “Factor” (a company that specializes in purchasing discounted receivables). Also called Invoice Factoring, small businesses commonly use it with limited credit history.

How do Accounts Receivables Factoring Works?

Usually, a business sells goods and services to its customers either in cash or credit. In the case of credit, the company sends an Invoice to the customers, which is typically paid back to the business as per credit terms (varies from business to business and the period ranges from 7 days to 180 days and even more).

Instead of waiting for the customer to make a payment on due dates (Duration of credit terms), a business can sell its accounts receivablesAccounts ReceivablesAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year. read more at a discount from their Face Value (Invoice Value) to the specialized company known as “Factor” and receive cash immediately.

Under Invoice Factoring, the discount (factor fees) charged by these companies depends on multiple factors, namely:

Due date of Receivable (Longer time frame will require more factor fees compared to a shorter time frame).The industry that the business belongs.The creditworthiness of Business Credit Customers;Collection history of the business on its receivables;Amount of Invoice Factoring assigned for factoring.Type of Factoring-Recourse or Non-Recourse (Discussed in detail below). Non-recourse factoring requires the factor to take additional credit risk arising from uncollectible accounts receivables, leading to more factor fees.

Types of Accounts Receivable Factoring

Let’s discuss the types.

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Under this Invoice Factoring arrangement, only the accounts receivables factoring companies provide only early payment of invoices in return for Factor Fees to the business. Suppose any bad debtBad DebtBad Debts can be described as unforeseen loss incurred by a business organization on account of non-fulfillment of agreed terms and conditions on account of sale of goods or services or repayment of any loan or other obligation.read morearises later due to nonpayment of dues by the customer resulting in a loss. In that case, the business will make it good for the accounts receivables factoring companies. In other words, the credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower’s failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt’s principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more remains with the original business, and in the unlikely event of any loss arising, the business will make good any loss to the factor. Under this, the whole debt collection process is taken care of by the business itself, and factor is paid Factor fees (the interest for advancing money against the invoice to the business from the date the advance was made to the date the business gives the factor the money).

The following equation can explain the same:

Example

Let’s understand the same as an accounts receivables factoring example:

Company A sends a Rs 10000 invoice to its customers to be paid in six months and a copy to its Factor, M/s X, in return for Rs 8500. On the due date (i.e., after six months), the customer pays the money, and Company A sends Rs 10000 to M/s X.M/s X charges 10% factor fees for the amount advanced to Company A and returns the balance amount to Company A.

The amount advanced by M/s X to Company A: Rs 8500Interest AccruedInterest AccruedAccrued Interest is the unsettled interest amount which is either earned by the company or which is payable by the company within the same accounting period.read more (Factor Fees): 10% of Rs 8500=Rs 850Invoice amount received: Rs 10000Accordingly, [10000-(8500+850)]=Rs 650Thus Rs 650 will be paid back by M/s X (Factor) to Company A after deducting factor fees to settle up the transaction with Company A.

Journal entry to record the same in the books of Company A will be:

Under this arrangement, a business sells its invoices to the factory and receives cash payments immediately. The factor takes all responsibility for analyzing the creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan.read more collection of payment on the due date, and credit loss arising on account of nonpayment by the customer (credit risk is transferred from the business to the accounts receivables factoring companies).

As evident from the above, Non-recourse factoring involves more risk and administrative cost for the factor and is usually more expensive compared to a Recourse FactoringRecourse FactoringRecourse in factoring refers to a process whereby an entity sells its invoices to the client (factor) with the condition that it will repurchase any invoices that remains uncollected. Thus, this type of factoring mitigates the risk of loss from uncollected invoices for the factor (client).read more for the business that utilizes Non-recourse factoring services.

Let’s understand the same as factoring of accounts receivable example:

Company A sends a Rs 10000 invoice to its customers to be paid in six months and a copy to its Factor, M/s X, in return for Rs 8500. On the due date (i.e., after six months), M/s X collects the same from the customer.

Benefits

Provides immediate cash flow to BusinessCash Flow To BusinessCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more;
Helps businesses to focus on rendering value services as payment collection hassle is taken care of by factor in return for the Factor fees.Provides a source of funding for businesses with low (or no) credit history as Invoice Factoring companies discount invoices based on the credit history of the customer and not the business;In the case of Non Recourse Factoring (discussed in detail below), the business is a guard from losses, if any, arising from Bad Debts (Uncollectible Accounts Receivable).

Conclusions

Accounts Receivable Factoring is a higher-cost source of funds and is used more by smaller firms that do not have a particularly strong credit history. There are other motivations behind opting for this financial instrument tool. It helps businesses focus on growing business and serving more clients rather than focusing on payment collection hassle, improves the cash conversion cycleCash Conversion CycleThe Cash Conversion Cycle (CCC) is a ratio analysis measure to evaluate the number of days or time a company converts its inventory and other inputs into cash. It considers the days inventory outstanding, days sales outstanding and days payable outstanding for computation.read more, and removes credit risk, to name a few. However, it is important to mention that at times (particularly in the case of Non-recourse Factoring), the factor may put extra pressure on the business customer for payment, which could hurt the firm’s future business prospects with these customers.

Accounts Receivable Factoring Definition Examples