Factoring is a word often incorrectly used synonymously with accounts receivable financing. In Europe, the term “factoring” has become the term for accounts receivable financing in general; but in the U.S., this term refers to a specialized form of financing that involves the actual transfer of the ownership of the receivable to the lender, more accurately known as American Factoring. Factoring is a financial transaction whereby a business sells its accounts receivable (i.e., invoices) at a discount. Factoring differs from a bank loan in three main ways. First, the emphasis is on the value of the receivables, not the firm’s creditworthiness. Second, factoring is not a loan but the purchase of an asset (the receivable). Third, a bank loan involves two parties, while factoring involves three.
The three parties involved in a factoring arrangement are the seller, the debtor, and the factor.
The debtor owes the seller money, usually from the purchase of goods or services. It is common in business-to-business transactions for a seller to offer terms that allow payment for goods or services at some time after the actual delivery and acceptance of the goods or services.
In factoring, the third party in this transaction, the factor, buys the invoice(s) from the seller, usually at a discount to allow for the factor’s return and with a reserve, which is a margin the factor holds back until the receivable is retired by the debtor. Upon receiving payment on the invoice at its full face value, the factor remits the reserve to the seller.
There are many misconceptions about factoring, although it is an extremely old form of financing. It was first used in the U.S. in the textile industry, which was an industry of small, rapidly growing businesses selling to large retail chains and clothing manufacturers. It was also a common form of financing commerce in England, and some rules for factoring are even found in the Code of Hammurabi, the first set of laws governing commerce in ancient Babylonia.
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