Factoring 101: What is Factoring?
In most business transactions, typically you have two entities: the buyer and the seller. The transactions involve the exchange of goods or services. However, some business transactions involves a third party. This type of transaction occurs when the seller of the goods decides to sell the invoices from goods or services to that third party, a factor. As a result, these three-party transactions are often referred to as factoring. This article is designed to give an in-depth definition of this three-party lending, taking into account both its advantages and disadvantages.
Factoring is a nontraditional lending arrangement. Reasons for businesses to go a nontraditional financing route vary. For one, a business may be newly established, with not as much of a credit history. Secondly, a business may have a poor credit history and be unable to obtain traditional credit. Finally, a company may need quick access to funds. Having ready access to funds is known as liquidation. Factoring provides a quick and easy way to liquidize assets for the seller.
The advantage to a factor relationship benefits mostly the seller and the factor. For the seller, they get a guaranteed payment by selling their invoices to a third party. For the factor, they gain accounts at a discount from which they can collect assets. As a bonus, the factors also get an opportunity to charge interest on any unpaid invoices. It is the interest rates that the factors can charge that maximize their potential for profit.
Though both the seller and the factor benefit from a factor relationship, some consequences exist. Before entering into a factor contract, sellers should check the reputation of the factor. Sellers should also make sure their buyers are fully aware of the factor transaction prior to the sale. Because buyers are subject to interest from factors, the third party interference could risk the relationship that a seller has with the buyer, especially if the buyer is in a long-term relationship with the seller.
Factoring can be a lucrative business. For the factor, the advantages are obvious. However, it can be a high-risk venture for sellers as a potential threat to their future business transactions. For the buyer, the original party in the factor arrangement, there is also a substantial risk if the amount of interest in the factor relationship reaches exorbitant amounts. Yet with right balance, all parties can come to a mutually satisfying resolution. If you have any questions, don’t hesitate to give us a call.