Accounts Receivable (AR) Factoring

Accounts receivable factoring is a financial transaction where a business sells its accounts receivable (invoices) to a third party, known as a factor, at a discount.

What is Accounts Receivable Factoring?

Accounts receivable factoring is a financial transaction where a business sells its accounts receivable (invoices) to a third party, known as a factor, at a discount. This provides the business with immediate cash flow and transfers the responsibility of collecting the receivables to the factor. Here’s a detailed look at accounts receivable factoring:

How Accounts Receivable Factoring Works

1. Sale of Receivables: The business (seller) sells its accounts receivable to a factor (a specialized financial institution or factoring company). The factor advances a significant portion of the invoice amount to the business immediately, often between 70% to 90%.
2. Discount Fee: The factor charges a discount fee or factoring fee, which is typically a percentage of the invoice amount. This fee compensates the factor for the risk and administrative costs associated with collecting the receivables.
3. Collection: The factor takes over the responsibility of collecting the receivables from the business’s customers. Once the factor collects payment, they retain the discount fee and remit the remaining balance to the business, minus any additional fees or charges.
4. Final Payment: After the receivables are collected, the factor pays the remaining balance to the business, usually after deducting the agreed-upon discount fee.

Example of Accounts Receivable Factoring

1. Invoice Details: A business has an invoice for $100,000 that it wants to factor.
2. Advance Rate: The factor offers to advance 80% of the invoice amount. This means the business receives $80,000 immediately.
3. Factoring Fee: The factor charges a 3% fee on the invoice amount. The fee is $3,000 (3% of $100,000).
4. Final Payment: Once the factor collects the $100,000 from the customer, they deduct the $3,000 fee and remit the remaining $17,000 ($100,000 – $80,000 advance – $3,000 fee) to the business.

Journal Entry Example:

• When the business factors its receivables:
  • Debit Cash (for the advance amount): $80,000
  • Debit Factoring Fees Expense (for the discount fee): $3,000
  • Credit Accounts Receivable (for the full invoice amount): $100,000

Types of Factoring

1. Recourse Factoring: The business remains liable if the customer does not pay the invoice. In this case, the factor has the right to seek payment from the business for any uncollected receivables.
2. Non-Recourse Factoring: The factor assumes the risk of non-payment by the customer. If the customer defaults, the factor absorbs the loss, and the business is not liable.

Advantages of Factoring

• Improved Cash Flow: Provides immediate cash flow to the business, which can be crucial for operations and growth.
• Outsourced Collections: Transfers the responsibility of collections to the factor, allowing the business to focus on other activities.
• No Debt Incurred: Unlike loans, factoring does not create a liability on the balance sheet.

Disadvantages of Factoring

• Cost: The factoring fees can be expensive compared to other forms of financing.
• Customer Relationship: Customers may be aware that their payments are being managed by a third party, which can affect their perception of the business.
• Dependence: Relying heavily on factoring for cash flow might signal financial instability to stakeholders.

Summary

Accounts receivable factoring can be a useful financial tool for businesses needing quick access to cash and willing to pay a fee for the service. It involves selling invoices to a factor, who provides immediate cash and handles collections, in exchange for a discount fee. Businesses must weigh the benefits against the costs and potential impact on customer relationships when considering factoring.