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INTRODUCTION

Factoring

is afinancial transactionwhereby a business sells itsaccounts receivable(i.e.,invoices) to a third party (called afactor) at a discountin exchange for immediate money with which to financecontinued business. Factoring differs from abank loanin three mainways. First, the emphasis is on the value of thereceivables(essentially afinancial asset), not the firm’scredit worthiness. Secondly, factoring is not aloan– it is the purchase of afinancial asset(thereceivable). Finally, a bank loan involves two parties whereas factoring involves three.It is different from theforfeitingin the sense that forfeiting is atransaction based operation while factoring is a firm-based operation -meaning, in factoring, a firm sells all its receivables while in forfeiting,the firm sells one of its transactions.Factoring is a word often misused synonymously with

invoice discounting

. Factoring is the sale of receivables whereas invoicediscounting is borrowing where the receivable is used as collateral.The three parties directly involved are: the one who sells thereceivable, thedebtor, and the factor. Thereceivableis essentially a financial assetassociated with the debtor’sliabilityto pay money owed to the seller (usually for work performed or goods sold). The seller thensells one or more of its invoices (thereceivables) at adiscountto the third party, the specialized financial organization to obtain cash. The saleof thereceivablesessentially transfers ownership of thereceivablesto the factor, indicating the factor obtains all of the rights and risksassociated with thereceivables. Accordingly, the factor obtains the rightto receive the payments made by the debtor for the invoice amount andmust bear the loss if the debtor does not pay the invoice amount.Usually, the account debtor is notified of the sale of the receivable, andthe factor bills the debtor and makes all collections. Critical to thefactoring transaction, the seller should never collect the payments madeby the account debtor; otherwise the seller could potentially risk furtheradvances from the factor.

There are three principal parts to the factoring transaction;a.) the advance, a percentage of the invoice face value that is paid to theseller upon submission,b.) he reserve, the remainder of the total invoice amount held until thepayment by the account debtor is made andc) he fee, the cost associated with the transaction which is deductedfrom the reserve prior to it being paid back the seller. Sometimes thefactor charges the seller a service charge, as well as interest based onhow long the factor must wait to receive payments from the debtor. Thefactor also estimates the amount that may not be collected due to non-payment, and makes accommodation for this when determining theamount that will be given to the seller. The factor's overall profit is thedifference between the price it paid for the invoice and the moneyreceived from the debtor, less the amount lost due to non-payment.

DEFINITION

“Factoring is a service involving the purchase by a financialorganization, called a factor, of receivables owned to manufacturer anddistributors by their customers, with the factor assuming full credit andcollection responsibilities.”“Factoring is a service of financial nature involving the conversionof credit bills into cash.”