Factoring makes it possible for a business to convert a readily substantial portion of its accounts receivable into cash

Key Points

Key Terms


Factoring is a financial transaction whereby a business sells its accounts receivable to a third party (called a “factor”) at a discount. This provides the funds needed to pay suppliers and improves cash flow by accelerating the receipt of funds.

Money: Factoring makes it possible for a business to readily convert a substantial portion of its accounts receivable into cash.

Companies factor accounts when the available cash balance held by the firm is insufficient to meet current obligations and accommodate its other cash needs, such as new orders or contracts. In other industries, however, such as textiles or apparel, for example, financially sound companies factor their accounts simply because this is the historic method of finance. The use of factoring to obtain the cash needed to accommodate a firm’s immediate cash needs will allow the firm to maintain a smaller ongoing cash balance. By reducing the size of its cash balances, more money is made available for investment in the firm’s growth. Debt factoring is also used as a financial instrument to provide better cash flow control, especially if a company currently has a lot of accounts receivables with different credit terms to manage. A company sells its invoices at a discount to their face value when it calculates that it will be better off using the proceeds to bolster its own growth than it would be by effectively functioning as its “customer’s bank. ”

Types of Factoring

There are two principal methods of factoring: recourse and non-recourse. Under recourse factoring, the client is not protected against the risk of bad debts. On the other hand, the factor assumes the entire credit risk under non-recourse factoring (i.e., the full amount of invoice is paid to the client in the event of the debt becoming bad). Other variations include partial non-recourse, where the factor’s assumption of credit risk is limited by time, and partial recourse, where the factor and its client (the seller of the accounts) share credit risk. Factors never assume “quality” risk, and even a non-recourse factor can charge back a purchased account which does not collect for reasons other than credit risk assumed by the factor, (e.g., the account debtor disputes the quality or quantity of the goods or services delivered by the factor’s client).

In “advance” factoring, the factor provides financing to the seller of the accounts in the form of a cash “advance,” often 70-85% of the purchase price of the accounts, with the balance of the purchase price being paid, net of the factor’s discount fee (commission) and other charges, upon collection. In “maturity” factoring, the factor makes no advance on the purchased accounts; rather, the purchase price is paid on or about the average maturity date of the accounts being purchased in the batch.