Factoring is a process where businesses sell their receivables, that is, the money owed to them by other businesses, to a third party at a discount. It is quite often confused with accounts receivable financing, which is completely different.

In accounts receivable financing, a strong, creditworthy business uses its receivables as collateral to obtain a bank loan. In this case, the validity and credit standing of the firms that owe the money is not brought into question. The creditworthiness of the business owed the money is the only consideration.

If the business requesting financing is found to be sound, then a loan is given and the receivables are named as the collateral for the loan. When the receivables are collected, those funds can be used to pay off the loan – or not, depending on the determination of the business’ owner. As long as the loan is paid according to the terms granted, the income from the receivables can be used in any manner the owner sees fit.

Factoring functions in a completely different manner, beginning with the fact that the credit standing and overall financial health of the business to whom the money is owed is not brought into the equation. In fact, many startup companies, and other businesses that find themselves in a cash crunch, turn to factoring as a means of survival.

The receivables and the businesses that owe the money are the key to factoring. For example, new (but shaky) startup business ABC Corp. is owed $100,000.00 by solid-as-a-rock DEF Corp. on a sale to be paid in 90 days. ABC owes a lot of money on the cost of the sale that it had to pay out of pocket, and now must calculate the cost of waiting three months to collect the funds from DEF.

The accountant or comptroller of ABC then informs the CEO that they can’t wait 90 days to collect the funds. The CEO then weighs his alternatives, one of which would be to assign the receivable to a factoring company.

The CEO of ABC contacts the factoring company and makes a proposal. He explains that the need for the funds is immediate and provides invoices and payment terms from the sale made to DEF. The factoring company then checks with DEF and makes sure that the sale is legitimate and that DEF is satisfied with the products or services they purchased. It then does a credit check on the overall financial health of DEF and after finding their credit rating to be high, makes an offer to ABC.

The offer made to ABC is not made according to the same formulas that banks use to make loans to businesses. It is done on a strict, formulaic basis. The factoring company has determined that the risk of collecting from DEF is low and that is one end of the equation. They have also investigated and determined that ABC is eager but not desperate to collect the funds now. So they make an offer to purchase the $100,000 receivable at a discount.

The amount of the discount is not based on the prime rate or any other particular rate, but is determined on a case-by-case basis by the factoring company whose goal is to buy the receivable as cheaply as possible. The discount can range from as little as 5% for the 90-day period to as much as 15% and ABC has the right to respond with a counteroffer.

Once a negotiated discount has been achieved, the receivable belongs to the factoring company. In fact, DEF will be notified of the transaction and will be instructed to send the funds according to the term of the original invoice directly to the factor. ABC Corp is now “out of the loop,” having gotten its money from the factoring company, and it no longer has to collect the invoice from DEF. That responsibility now belongs to the factoring company.

Factoring can be a good business as long as the company that owes the money has a good track record of paying its bills. If that company defaults, the factoring company has no recourse with ABC unless there was fraud on their part. Even if the factoring company charged only 5% for the 90 days it waited to collect, that would amount to more than a 20% annual return.

While it appears that factors are taking advantage of small, struggling businesses, they are actually a major source of funding for comapnies that don’t qualify for financing from traditional sources. Assuming honest participants all around, factoring works quite well for all parties concerned.