What is it?

When institutional and corporate customers withhold payments to a business for its products and services due to shortage of funds or because they themselves are awaiting funds from their customers, the business generally resorts to third party financial agencies for quick cash equivalent in value to the due payment to keep their operations going. This practice is known as accounts receivable factoring, and such companies which make quick cash available are known as factoring companies, or simply as factoring firms.

Such a transaction usually involves handing over the rights to receive payment from the customer by the business to the accounts receivable factoring company. The factoring company disburses funds to the business and collects payments from the customer when it becomes due.

Why you need it?

Businesses today extend their products and services to their customers on credit. This is especially true for customers with whom a business has developed trust and healthy relationship. While the credit period is about one to three months normally, it is largely governed by the market and economic conditions. In an economic recession, for example, the credit period may go as high as six months due to fall in sales and shortage of liquid funds.

Few businesses, however, are equipped to keep up their daily business operations for that long from their own reserve of funds. Businesses which are not able to do so turn to accounts receivable factoring companies to take up their credit and disburse them necessary funds to keep their operations going. The business thus receives its due payment, either in full or almost full, while such companies then collect the due payment from customers when they are in a position to pay up.

Accounts receivable factoring, of course, comes at a price. There are charges and fees involved and it is essential that a business explore and compare different accounts receivable factoring companies and their terms and conditions before availing their services.

How different is it from Bank Loans?

Accounts receivable factoring is also known as 'securitization of business assets'. However, keep in mind that this finance concept is different from a bank loan. The first distinguishing factor is the applicable interest rate.

There is no interest rate in accounts receivable factoring; there is a discount rate instead. A discount rate of 5% means that for every $100 of receivable funds, the factoring company will disburse you only $95. That is $100 at 5% discount. This makes sense as the value of cash immediately available from the factoring company is more than the payment that would be made by the customers at a later date.

Accounts receivable factoring is a great service to avail for those businesses that are either short of reserve working capital or have just started operations and are therefore ineligible for bank loans.