Invoice Factoring Entails A Firm Offering Its Debtors At A Discount For Fast Payment    by Ben Pate

in Finance / PersonalFinance    (submitted 2011-02-17)

Invoice factoring may be described as a short-term financing technique. As such, it is a financial transaction in which a business sells its portfolio of invoices, and therefore the money it is owed by customers, to a factor firm, also known as an invoice discounter (the financier). This transaction is agreed at a price being at some discount to the full book value of the invoices. The discount is offered in return for an immediate lump sum payment. This form of financing is also called factoring receivables.

As a form of funding, factoring differs from a bank loan in at least three important ways. First, it focuses on the value of outstanding receivables from a debtor in possession, not the overall credit standing of the business. Second, factoring is not a loan; it involves the sale of an asset. Third, unlike a bank loan, it involves three distinct parties, not two (the factor firm, the operating business and the debtors).

Immediate payment clearly improves the cash flow of the trading firm and may also decrease the risk it incurs of debtors not paying their outstanding invoice (debt). Receivables discounting represents an attractive option for many businesses. It offers several advantages. Firstly, it results in accelerated cash flow allowing the business to better fund new sales. Secondly the business can, at its discretion, continue to offer its customers delayed payment terms. Thirdly, receivables discounting permits the business to take advantage of any early payment discounts terms its suppliers may offer.

The three parties involved in a factoring transaction are the trading business that sells its invoices, the debtors to that business and the factor firm. The sale of the receivables balance, essentially involves the transfer of ownership of that asset. In other words, the factor acquires all of the rights associated with those receivables, as well as the attendant risks.

Importantly, the business can continue to negotiate sales and other terms directly with customers. Its relationship with customers need not be affected by a factoring transaction. In many legal jurisdictions, this type of transaction need not be notified to customers. The collection of receivables (that is, the outstanding invoices from customers) may continue to be made seamlessly by the business without customers needing to be troubled with details of the changed ownership of their debt to the business.

Some factor firms set a threshold size limit for the firms they are willing to take on as customers. For example, a major commercial bank like HSBC might set an annual revenue limit of $10 million. Firms with sales below that limit are probably too small for HSBC to work with economically as a customer.

The factor firm makes an estimate of the amount of debtor non-payments (debtor defaults) it will be experience and builds this estimate into the discounted price it will pay for the invoices. In some case, the factoring firm may also charge the seller a service charge, as well as an interest amount based on how long the factor firm waits before receiving payments from debtors.

About the Author

Businesses wanting to discount their invoice factoring (invoices) through invoice factoring will be required by the invoice factoring financier to provide details of their debtor in possession. These details include standard items like trading name, contact address, the scope and nature of business activities, credit limit, and credit history. The financier will also require a detailed aged receivables schedule. This data will be analyzed by the factor firm to form a view regarding the default risk (credit worthiness) of each individual customer.