Factoring is selling your company's accounts receivable invoices at a discount to a third party for immediate cash.
When your accounting department chooses to factor their accounts receivable, it doesn't necessarily mean the invoices won't be paid on time. Factoring is an option for businesses that need cash flow faster than the allotted time for invoices to be paid.
How Does Factoring Work?
Factoring services help businesses that are struggling or in need of immediate cash flow. Invoice or accounts receivable factoring can be done a few different ways.
Invoice financing (also called invoice discounting) involves setting up a line of credit for your business. This credit line allows your accounting department to send invoices as collateral in exchange for borrowing against your credit. When your client pays the invoice, your business pays back the borrowed credit plus any fees. In this arrangement, the client still sends payment to your business.
Invoice selling (also called invoice factoring) involves selling your accounts receivable invoices to a factoring company at a reduced rate. As an example, the factoring lender may pay your company 80% of the total invoice and then hold the other 20% until your client pays in full. When your client pays, they then pay you the final 20% minus any factoring fees. With this arrangement, your client is instructed to pay the factoring lender.
Factoring services lenders will specify that your company do due diligence and credit checks on your clients. They may also limit the due date allowed on your invoices so they're able to recover their financing quickly. The services and percentages offered may also be different, depending on your market and the size of the transaction.
Learn more: Factoring vs. Collections
To reiterate, factoring involves selling accounts receivable invoices for immediate cash. These invoices are collectible and are sent to clients who are expected to pay on time. Collections efforts of accounts receivable invoices that have been factored are no longer the responsibility of the company that sold them, but of the factoring service.
If clients are not paying their invoices on time, they would not be available for factoring. Instead, these invoices are considered bad debt and should be sent to collections.