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Factoring as a Source of Small Business Financing

Factoring is a source of finance for small businesses. Factoring is a financial transaction between a business owner and a third party that provides instant cash to the former in exchange for the account receivables of the business.

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Factoring is a source of finance for small businesses. Factoring is a financial transaction between a business owner and a third party that provides instant cash to the former in exchange for the account receivables of the business. In other words, a cash-strapped business, unable to get desperately needed funds, sells off its invoices, that are called account receivables, to a third party and in exchange, gets the much needed cash.

Account receivables are an asset belonging to the business, but they are generally sold at a discount, since the third party will agree to pay cash only if it is making some profit in the bargain. The discount obviously reduces the profit the small business may have made, but it gets the money needed to continue operations.

Factoring is not a loan, but a sale of invoices of the business. It falls in the same category of financial instruments as forfeiting and invoice discounting, all of which enable the small business to raise funds. Factoring involves the sale of all the receivables of the business and is a firm based operation. On the other hand, forfeiting involves the sale of only one of its transactions and is therefore considered to be a transaction based exercise having no connection with the other transactions. Similarly, invoice discounting is distinctly different from factoring since it is similar to a loan in which the receivable is used as collateral.

Factoring offers the advantage of getting quick cash, secures the debts incurred by the business, reduces the risk of bad debt and helps to ensure a smooth cash flow. The factor in turn makes money since he buys the account receivables at a discount.

Factoring works with three parties. The seller is the person selling the receivable. The receivable is an asset since it is the amount owed to the seller for goods sold or services rendered. The third party is an organization interested in buying the receivable at a discount from the seller and pay cash. The seller transfers his ownership rights for the receivable to the third party, and the latter also ends up with the risk involved in case of non-payment of dues.

Thus factoring has three components in the financial transaction:

  1. Advance-this is a certain percentage of the face value of the invoice, paid to the seller when he submits them for sale
  2. Reserve-this is the amount that is kept till the debtor makes the invoice payment
  3. Fee-this is the amount charged by the factor as the cost of the transaction, and is deducted from the reserve and paid in the end upon receipt from the debtor.

The factor takes into account the risk involved in case of non-payment by the debtor and accounts for it while deciding on the amount to give to the seller.

Features of factoring

  • The factoring period generally ranges between 90-150 days.
  • It is an expensive method of short term borrowing
  • Appropriate for new firms without a credit history, since it is given on the basis of the credit worthiness of the firm’s customers and their ability to clear their dues.
  • The factor always conducts due diligence and a credit risk analysis before providing funds for the small business.
  • Factoring can be disclosed or undisclosed, recourse or non-recourse.
  • Many companies offer factoring facilities to businesses.

Though expensive as compared to other kinds of small business financial instruments, factoring is frequently used to get immediate cash to keep the business running.

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