Factoring literally means selling the accounts receivable to a company, known as a factor, on a contract basis to avail cash payments before the accounts come in due. The factor is then responsible for all future credit analysis of credit losses, all accounts and payment collections. To put it in a nutshell, factoring is the short-term, non-bank financing of accounts receivable. Factoring can thus also be included in a type of off balance sheet financing.
The factor cannot return to the seller in case of nonpayment of due courses.
Factoring is usually carried out in two basic ways:
- Notification basis allows the seller’s customers to remit directly to the factor.
- Non-notification basis: Here the seller handles the collection and remits to the factor.
Factoring has four types whereas many industries only deal with the first two broad types:
Maturity Factoring (also referred to as service factoring): the factor retains the seller’s credit, sales ledger and follows up payments and pays the amount after deducting a commission of each invoice regardless of the payment been paid yet or not.
Finance Factoring: In this type the factor gives or rather lends funds to the manufacturer or producer firm of a certain product on the guarantee of the products produced using those funds.
Discount Factoring: the factor allows a percentage to the seller on non-recourse basis and assumes full responsibility of collecting debts. This percentage is usually 70 to 85% of the value of accounts receivable.
Undisclosed Factoring: This method allows a factor to buy products from a primary party and to assign then the same party to resell these products and to gather the payments in return.
No matter what type we take into account, all types of factoring makes the factor liable for uncollected payments. Factoring is most often used in seasonal industries such as textile and shoes where to shift the functions of credit and collection to a specialized agency.