There are many business events and scenarios when the company is in dire need of financing. One option is to go for a bank loan or issue public debt. But can these methods be a good option for quick financing?
Oh, maybe then you should go for a ‘line of credit.’
But, the legal process is not that smooth and easy. You must prove your business to be creditworthy.
Another alternative is there for obtain instant cash without sacrificing your assets as collateral or long waiting periods.
Yes, factoring is a very old technique dating back to 2000 B.C. In modern days, it has revolutionized with A.I. software and a quick approach.
In this article, we’ll walk through the complete process of account receivables factoring. Let’s start with the definition of factoring.
What Is Factoring Of Account Receivables?
Factoring is famous with so many names. Discounting of account receivables, debtor financing, selling account receivables are some substitute names. Another name often is wrongly associated with factoring is “account receivable financing”.
If we talk about the origin of factoring, it has its origin as old as 2000 B.C. Garments business was the first industry that employed modern factoring during the 1300s in England.
In the 1600s, when American colonists were trading different products to be shipped across the Atlantic, they employed factoring for advance payments.
The period of the 1800s was marked by the industrial revolution across the United States and Europe. Hence the factoring for creditworthy customers became a common business practice.
Then came the decade of 1910, when invoice factoring was used in the textile industry by Americans for acquiring raw materials.
The advancements continued making factoring a banking practice in the U.S. during the 1940s. Interest rates and regulations on factoring in the 1970s & 1980s, and bigger bankers got involved in banking during the 1990s.
Finally, the era of technological breakthrough, factoring, got a space in cloud-based software, platforms, and IoT during the 2000s. It is still evolving to date.
The factoring of account receivables can be defined as,
A type of financial transaction between the business that is selling its account receivables and the third party who is buying the account receivables. The term factoring refers to discounting of your account receivables.
In other words, the company sells its account receivables at a lower price than the face value. The difference between the face value and the discounted price is the third party’s fees which are buying the receivables.
Who Is A Factor?
Before the formal commercialization of the factoring process, mostly merchants used to factor in each other’s receivables.
However, then the concept was adopted by the financial institutions. Third-party companies, the name was given to the buyer of account receivables.
The factor is the third-party company, financial institution, or buyer who purchases the account receivables of other companies at a discounted price. Another notion of factor is also very popular.
The term factor is referred to the merchant or agent who sells goods on commission. The modern concept of factor and factoring has also been derived from the old day’s merchants who used to sell goods for commission.
Why Does A Company Go For Factoring Of Account Receivables?
An important question to answer before we look into the process of factoring account receivable is:
Why would a company go for factoring its account receivables?
The most common reason why companies opt for factoring is to meet their short-term working capital needs. What happens to small businesses is that they often want to keep those bigger clients bringing most of their business.
On the other hand, the bigger commercial clients, except for terms of credit to span over 60 days or 90 days. It becomes a tough situation for small businesses in their growth stage. Therefore, they prefer to meet their short-term needs by factoring in the receivables.
The benefits are two-sided. First, a business doesn’t have to agree to complicated interest terms of banks for a loan. Secondly, they get instant access to cash with no uncomprehending terms and conditions.
Process Of Account Receivables Factoring: Step-By-Step
Let’s come to the point of how does it actually work. Let’s get into the process of factoring of account receivables.
Step 1: Presenting Invoices Of Account Receivables To Factoring Company
When a company wants to factor in its account receivables, it will look for a well-reputed factoring company. The invoices are presented to the factoring company.
However, most businesses create a backup of their invoices for any future and legal correspondence. The factoring companies will verify your invoices for sales of goods or services.
Step 2: Invoice Submission And Reserve Is Kept With Factoring Company
Once the invoices are submitted, the factoring company issues 80% to 95% of proceeds to the selling company on the same day or in the next two days.
The remaining percentage of the invoice value is kept with the factoring company as a reserve. The reserve remains with the factoring company until the payments are cleared by the debtors of the selling company.
For instance, if a company has presented account receivables of $200,000 for factoring, the proceeds will amount between $160,000 to $180,000.
Step 3: Payments Is Collected From The Debtors Of Business
According to the debt terms of 90 days or 60 days, the factoring company collects the amount as mentioned in the invoices.
Step 4: Remaining Payment Is Made To Business
After the factoring company collects the payments from the company’s debtors, it’s time to issue the remaining proceeds kept as reserve.
The seller of account receivables will not be entitled to 100% of the invoice value. A factoring agent that is a financial institution will charge fees or commission for collection from the debtors.
The fee amount can vary among different factoring agents. However, it lies within the bracket of 1% to 3% of the invoice value in most cases.
All terms and conditions like fees, reserve amount, and other conditions are pre-decided at the time of invoice submission.
Types Of Account Receivable Factoring
There are two types of account receivable factoring depending on the terms and conditions of the agreement. We have tried to comprehend both types with examples.
Transfer Without Resource
When a factoring company agrees to transfer account receivables without the resource, the selling company has transferred its complete risk to the factoring agent.
In other words, if the factoring company fails to collect payment from the debtor, they cannot demand the money back from the selling company. The selling company doesn’t owe anything for the uncollectible receivables, and the whole liability stays with the factoring agent.
For instance, let’s take the example of Al-Jazaeer, who has transferred its account receivables without resource to a factoring agent ABC. The amount of account receivables is $400,000,000. The reserve amount is around 10% of the invoice.
As a result, the company will write off its account receivables by debiting cash received and interest expense. In this journal entry, the amount of interest paid will be considered the cost of getting cash earlier than expected.
Transfer With Resource
When the factoring agent and selling company agrees on the transfer with resource, the risks are not transferred. If the payment attempts are failed the factoring agent can claim back its money from transferring company.
If we apply the same example of Al-Jazeera company by changing the condition of factoring. We assume that factoring agent ABC has agreed to transfer with the resource. The difference will be in the way of making journal entries and treatment of account receivables.
The cash amount will be debited. The amount of reserve kept with the factoring agent will also be debited. Whereas, instead of crediting account receivables, the transferring company will credit the short-term debt.
|Due From Factor(Holdback)
When the company has collected the amount from the debtors, let’s assume $10 million remained uncollectible. The treatment in the books of transferring companies will be shown in another entry.
This entry will comprise a debit cash balance for remaining proceeds, debit allowance for doubtful debts, and amount due from the factor credited.
The second entry will be passed for writing off the short-term debt. The short-term debt amount in the first entry will be debited along with interest expense as decided at the time of the agreement. On the credit side, account receivables will be written off for the full amount.
|Allowance for bad debts
|Due to factor(holdback)
Factoring is a financing technique like many other financing sources available for businesses. The benefit of factoring over other modes of financing is a quick and easy process. Besides, there is no need to keep other assets of the businesses as collateral.
We have tried to comprehend the concept of factoring for all small businesses and accounting enthusiasts out there. 😊