What is meant by the term "Factor"?
A factor is a funding entity that buys account receivables from the companies and provides cash or financing in return. This financing process is also called accounts receivable factoring. The factor collects money from the company's customers on the receivables. Factoring is the provision of a credit management service for the collection of outstanding sales invoices. The factor is a legal entity that offers the option of obtaining payments against the unpaid receivables before the due date.
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What are accounts receivable?
The majority of businesses function by allowing some of their sales to be made on credit. The amount that a firm is entitled to receive from its customers for goods or services offered on credit is referred to as accounts receivable. Accounts receivables are also known as trade receivables. Accounts receivable is the amount that is yet to be received by the firm within a specific duration. It is a short term asset and is thus classified as current assets. The total accounts receivables are presented in the asset column of the balance sheet as of the date of financial statement preparation.
Given the large number of credit sales that companies may have, accounts receivables hold a significant amount of cash- this simply means that a certain amount of money is unavailable until it is paid. If these are not handled effectively, they directly impact the business's working capital and can potentially stifle its growth.
What is accounts receivable factoring?
When a company, referred to as the factor, buys an accounts receivable invoice from another company, it is known as accounts receivables financing or debtor financing. Accounts receivable are discounted for the buyer or the factor to profit from the debt settlement. Factoring essentially transfers account ownership to a third party, who subsequently collects the loan.
Factoring relieves the first part of a debt for a fraction of the total amount owed, allowing them to continue trading while the buyer, or factor, pursues the debt for the entire amount owed and profits when it is paid. Once the loan is resolved, the factor is obliged to pay extra fees, usually a modest amount. The indebted party may also be offered a discount by the factor.
What are the ways in which the factor does financing?
A factor can do factoring of accounts receivables without recourse or with recourse. If the factor cannot collect from clients, the factor might demand money back from the entity that transferred receivables. In factoring without recourse, the factor assumes all of the risks of the money due but not received. Uncollectible receivables are not the responsibility of the entity that transferred receivables.
What is the importance of a factor?
The role of a factor can be explained with the help of the following example-
Company X is a processed food manufacturing company. On 1st January 2020, its credit sales to Company Y was worth US$30,000, for which it issued an account receivable invoice to Company Y with a maturity date of 30th March 2020. On 15th January, the factor, Company M, negotiates to discount the invoice by 3% and instantly transfers US$29,100 to Company X. The factoring fees charged by Company M amounts to US$900. On or before 30th March 2020, Company Y will pay US$30,000 to Company M.
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The factor provides positive cash flow and allows the company to develop without taking on further debt. Companies can have operating cash when traditional bank finance is difficult to come by. Because factoring companies are concerned with the volume of accounts receivable and the payment history of your purchasers, the approval process is less time consuming than obtaining a bank loan. Cash is available much more quickly than bank loans. Factoring accounts receivables is not a loan. The company sells its bills for less than its face value to an accounts receivable factor. The factor right away pays cash to the company cash. Thus the company does not have to wait to get paid. In most cases, the factoring company assumes the risk of servicing and collecting outstanding accounts receivable payments- this removes the possibility of write-offs or unpaid invoices. Collecting invoice payments is no longer a time-consuming task.
Without additional debt liability, there will be scope to fund or increase marketing expenses, purchase additional raw materials, improve operational efficiency, increase revenues, pay their staff better, hire experts in the field and pay their financial obligations without default. The cash flow gives them a competitive advantage over those waiting for their bills to be paid. It also helps the company by allowing them to inject the money back into their company to grow and develop.
What could be the problems associated with seeking the services of a factor?
A potential issue with factoring is that the factor's interference between the actual debtor company and the factor's client could jeopardise trading ties and destroy goodwill because customers may prefer to deal with the company. When using a non-recourse factoring service, the client relinquishes control over credit decisions for its debtors, who may be regular customers. Customers may object to being followed up for payment by a third party. Furthermore, suppose the company’s customers learn that it is utilising a factor to collect debts. It may raise concerns and create opinions that the company is experiencing cash flow problems, which may impact customer sentiments.