What Does "Factoring" Mean in Accounting?

By Kathy Adams McIntosh, eHow Contributor 

updated: February 25, 2011
Companies choose to sell their products or services on credit to entice customers to make
purchases. At times, these companies find themselves in a financial bind, lacking the cash to pay
creditors or order supplies. These companies may obtain financing from a bank using their
accounts receivable as collateral. Or they may choose to factor the accounts receivable.

1. Accounts Receivable
o Accounts receivable represent promises to pay from the customers. Companies
allow customers to buy on credit for several reasons. A primary reasons is to remain competitive
against other companies who offer credit to customers. The company also wants to encourage
customers to purchase before they change their mind. By convincing the customer to purchase
the item, the company can recognize the sale.

Factoring Accounts Receivable

o Some companies choose to factor accounts receivable to obtain needed cash
without waiting for customers to pay. Factoring involves selling the right to collect the balance
due on the accounts receivable from the customers to another entity. This entity is called a factor
and is usually a bank or finance company. The factor pays the business in two or more payments.
The first payment represents a portion of the accounts receivable being factored. The factor
makes future payments as it collects from the customers.
Cost to Factor Accounts Receivable
o Factoring accounts receivable comes at a financial cost to the company. Factors
charge companies a percentage of the total accounts receivable in exchange for making an
immediate payment to the company and incurring the collection expenses. The factor deducts
the charge from the payments it makes to the company.

Reasons to Factor Accounts Receivable

o Companies choose to factor their accounts receivable for several reasons. Some
companies lack the resources to follow up with overdue customers and enforce collections.
Others need some immediate cash to meet other obligations, and factoring allows them to
receive a partial payment right away. The company may also hold a bank loan and not want to
pursue that option for the additional cash.

Reasons Not to Factor Accounts Receivable

o In addition to the financial cost, factoring accounts receivable brings nonfinancial
costs. Investors and customers perceive companies who factor accounts receivable as a
struggling business. This motivates investors to put their money into other companies and
customers to shop at other businesses. Public perception can damage the reputation of the
company.

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