Factoring: What is it and why is it important for financing a company?

Factoring is a process by which a company assigns its accounts receivable to a specialized financial institution, known as a factor. In return, the company obtains immediate liquidity to meet its urgent financial needs. The factor purchases the company’s outstanding invoices at a discount, and assumes responsibility for collecting from customers. In this context, you may find useful an invoice template Word.

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The Spanish Factoring Association (AEF) reveals that this financial mechanism experienced an impressive growth of 11.5% during 2021, and reached a monumental figure of 98,979 million euros.

In other words, factoring can be understood as the process of transforming credit sales into cash. Actually, its essence is based on providing financial solutions, supplying funds, collection management and commercial advice.

Actors in Factoring

The factor

The factor is the financial entity that purchases unpaid invoices at a discount previously agreed with the client. Its main function is to purchase these invoices and manage the collection from the corresponding debtors.

In general, the main entities engaged in this activity are banks, within which there are also financial corporations, finance companies, and savings and credit cooperatives.

The factor takes charge of the purchase of invoices with terms and conditions already agreed between the client and the debtor. These payment terms are generally established in periods of 30, 60 or 90 days.

The customer

Also called the assignor, this is the person or company that seeks to obtain liquidity by negotiating its outstanding invoices. To do so, it sells these invoices to the factor or financial institution, which implies transferring the credits or rights it has over these debts to third parties.

The debtor

The person or entity that is responsible for paying the amount of money specified on the invoice. When the customer sells its invoices to the factor, the factor becomes the new creditor, and the debtor is obligated to pay the full amount of the invoices when due.

Although not a direct participant in the factoring transaction, the debtor is mentioned for a complete understanding of how this transaction works. The main parties involved in the factoring contract are the factor and the client.

Diversity of factoring modalities

Depending on the agreements made between the company and the financial institution, there are several types of factoring:

• Non-recourse factoring: The financial entity assumes the risk of non-payment by the debtor. This is the most common and widespread type.
• Factoring with recourse: In this modality, the company using factoring is responsible for facing the debtor’s insolvency risk.
• Factoring with notification: The financial entity informs the debtor that the invoice has been assigned. From that moment on, the debtor is legally obliged to pay the agreed amount to the financial entity.
• Factoring without notification: In this variant, the debtor is not notified about the assignment of the invoice, so he/she makes the payment directly to the company.
• Agency factoring: This type of factoring allows the assigning company to assume the role of collection agent on behalf of the financial institution, regardless of the previous choice. This implies that the assigning company manages the collection of the assigned receivables and subsequently remits the funds received from the debtors to the financial institution.
• Factoring with/without globality: In all the previous types, the contract may stipulate that the company must assign the totality of its invoices on one or several debtors, or even on all the debtors included in the operation.

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Advantages of factoring

Factoring offers several significant advantages as a financial practice:

1. Improved liquidity: One of the greatest benefits of factoring is its ability to improve companies’ liquidity immediately. Companies can convert their accounts receivable into cash, allowing them to have funds available for day-to-day operations, vendor payments and investment opportunities.
2. Reduced risk of uncollectible accounts: By assigning receivables to a factoring entity, the company transfers the risk of uncollectible accounts to the factoring entity. This helps protect the company from financial losses related to bad debts and allows it to concentrate on more productive activities.
3. Accelerating the cash cycle: Factoring accelerates the cash cycle by avoiding the long lead times associated with accounts receivable. This allows companies to quickly have funds available to finance their operations and expand.
4. Access to quick financing: Unlike traditional loans, factoring provides access to financing more quickly and easily. This is especially useful for companies facing urgent cash needs.

Factoring Disadvantages

In addition to the benefits, factoring also has disadvantages:

1. Associated costs: factoring is not free. Companies must pay a fee for the service, which can reduce their capital. In addition, discount rates and uncollectible risk charges can also affect profitability.
2. Impact on customer relationships: Assigning receivables to a factoring entity can affect the relationship between the company and its customers. Some customers may feel uncomfortable dealing with a third party instead of the original company. However, in most cases, this concern is unfounded. Factoring companies are usually professional and discreet when interacting with clients, and many times, relationships are not adversely affected.
3. Continued dependence: Factoring can become a long-term solution to cash flow problems, which could create a continued dependence on this service rather than effectively addressing the underlying causes.
4. Eligibility criteria: Not all companies are eligible for factoring. Factoring entities evaluate the credit quality of the company’s customers before accepting their receivables, which could limit the availability of this service for some companies.

The Future of Factoring and its Impact

As factoring continues to expand in popularity, its evolution and adaptation to changing market needs are inevitable. Today, companies are adopting this financial tool as a strategy to drive growth and maintain financial stability.

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