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What is 'Factoring'
Definition: Factoring is a type of finance in which a business would sell its accounts receivable (invoices) to a third party to meet its short-term liquidity needs. Under the transaction between both parties, the factor would pay the amount due on the invoices minus its commission or fees.
Description: In order to meet short-term liquidity needs, a business has to sometimes resort to factoring. It is slightly different from invoice financing. There are four main types of factoring - maturity factoring, finance factoring, discount factoring, and undisclosed factoring.
The terms, as well as the nature of factoring, could differ from financial institution. The advance rate could vary from 80 per cent to about 90-95 per cent of the total invoice amount. Once the factor collects payments from the creditors, it pays back the rest of the money after deducting its fee or commission.
The only benefit of factoring is that a company doesn't have to wait for two or three months and can address its liquidity needs by approaching a financial institution.
Let's understand factoring with the help of an example. You own a business and you have accounts receivable pending with you which will be due after three months. But in the meantime you need access to cash to address immediate liquidity needs.
To gain access to cash, you approach a factor or a financial institution who has agreed to purchase your invoice worth Rs 10,00,000 from ABC Ltd. The factor may choose to discount the invoice at 4 per cent and will keep RS 40,000 as part of his/her commission. The balance amount is Rs 9,60,000.
Now, the factor might not advance the entire amount of Rs 9,60,000. It would only give around 75 per cent of that which is Rs 7,20,000 in the first tranche and the rest (Rs 2,40,000) when the financial institution receives balance payment from the customer.
Description: In order to meet short-term liquidity needs, a business has to sometimes resort to factoring. It is slightly different from invoice financing. There are four main types of factoring - maturity factoring, finance factoring, discount factoring, and undisclosed factoring.
The terms, as well as the nature of factoring, could differ from financial institution. The advance rate could vary from 80 per cent to about 90-95 per cent of the total invoice amount. Once the factor collects payments from the creditors, it pays back the rest of the money after deducting its fee or commission.
The only benefit of factoring is that a company doesn't have to wait for two or three months and can address its liquidity needs by approaching a financial institution.
Let's understand factoring with the help of an example. You own a business and you have accounts receivable pending with you which will be due after three months. But in the meantime you need access to cash to address immediate liquidity needs.
To gain access to cash, you approach a factor or a financial institution who has agreed to purchase your invoice worth Rs 10,00,000 from ABC Ltd. The factor may choose to discount the invoice at 4 per cent and will keep RS 40,000 as part of his/her commission. The balance amount is Rs 9,60,000.
Now, the factor might not advance the entire amount of Rs 9,60,000. It would only give around 75 per cent of that which is Rs 7,20,000 in the first tranche and the rest (Rs 2,40,000) when the financial institution receives balance payment from the customer.
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