Factoring refers to one of the ways of raising money for a business that is already in operation. Money raised is mainly for expansion or improvement of the business. Factoring is mainly done when an individual does not want to borrow money from banks. The reason could be that they already have an existing loan with the bank. The financial institution (factor) advances the business owner money against proceeds from the business owner's outstanding accounts receivables.
Factoring is done when a business owner, for instance Philip Thow, sells his accounts receivables to a financial institution at a discount. In the course of conducting business, the business owner sells goods and services to clients. Most times, the clients may not pay Phil Thow immediately. These customers are normally invoiced by Phil Thow and they are then expected to pay the business owner within some specified period of time. The accounting term for these outstanding obligations is accounts receivables. This is when factoring comes in.
The financial institution then becomes responsible for collecting the debt owed to Philip Thow. Philip Thow will then notify the customers of the transaction made by the financial institution. The customer will then be required to remit invoice payments directly to the institution and not to Phil Thow. This is one of the differences between factoring and a bank loan - in factoring the agreement includes the customer while in a bank loan the agreement is between the business owner, in this case Philip Thow, and the bank.
It should be noted that the accounts receivables are not collateral. If this were so, then the agreement would be invoice discounting where the loan is given with the accounts receivables acting as security. Here the accounts receivable are actually sold to the financial institution. Factoring is mainly done by financial institutions that are registered and may not necessarily be the local bank.
Most businessmen like Philip Thow may prefer factoring because money received from this agreement is not a loan. It also assists those that cannot receive money from banks because of outstanding credit or because the business could not qualify for a loan. Factoring is also done when a business owner like Phil Thow requires cash instantly that they are not able to get from their local banks.
Factoring is more expensive than bank lending but business owners prefer it when they are not credit worthy because in factoring it is the debtor who has to be credit worthy and not the owner of the business. Many people advice that factoring should not be used as the first option for getting money for the business because it is expensive and prefer getting funds from banks, which charge a lower interest. Factoring is also difficult when one does not have the necessary documents that show the exact values for account receivables owed.
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