Factor Definition: Requirements, Benefits, and Example (2024)

What Is a Factor?

A factor is an intermediary agent that provides cash or financing to companies by purchasing their accounts receivables. In short, a factor is a funding source; the factor agrees to pay the company the value of an invoice—less a discount for commission and fees.

Factoring can help companies improve their short-term cash needs by selling their receivables in return for an injection of cash from the factoring company. The practice is also known as factoring, factoring finance, and accounts receivable financing.

Understanding a Factor

Factoring allows a business to obtain immediate capital in the amount of the anticipated future income due from all outstanding invoices. These invoices are captured in accounts receivable, an asset account on a company's balance sheet, which represents money owed to the company from customers for sales made on credit. For accounting purposes, receivables are recorded on the balance sheet as current assets since the money is usually collected in less than one year.

A company can experience cash flow shortfalls when its short-term debts (or bills) exceed the revenue being generated from sales. If a company has a significant portion of its sales done via accounts receivables, the money collected from the receivables might not be paid in time for the company to meet its short-term accounts payable. As a result, companies can opt to sell their receivables to a factor and receive cash.

There are three parties directly involved in a transaction involving a factor: The first party is the company selling its accounts receivables. The second party is thefactor that purchases thereceivables. Finally, the third party is thecompany's customer,who must now pay the receivable amount to the factor (rather than paying the company that was originally owed the money).

Requirements for a Factor

Although the terms and conditions set by a factor can vary depending on its internal practices, the funds are often released to the seller of the receivables within 24 hours. In return for paying the company cash for its accounts receivables, the factor earns a fee.

The company selling the receivables transfers the risk of default by its customers to the factor. As a result, the factor must charge a fee to help compensate for that risk. Typically, a percentage of the receivable amount is kept by the factor; however, that percentage can vary, depending on the creditworthiness of the customers paying the receivables.

If the financial company acting as the factor believes there's an increased risk of incurring a loss—due to the customers not being able to pay the receivable amounts—they'll charge a higher fee to the company selling the receivables. If there's a low risk from collecting the receivables, the factoring fee charged to the company will be lower.

The duration of time the receivables have been outstanding or uncollected can impact the factoring fee, too. Some financial institutions that provide factoring may have additional terms and conditions. For example, a factor may want the company to pay additional money in the event one of the company's customers defaults on a receivable.

Benefits of a Factor

The company selling its receivables gets an immediate cash injection, which can help fund its business operations—or improve its working capital. Working capital is vital to companies because it represents the difference between its short-term cash inflows (such as revenue) versus the short-term bills or financial obligations (such as debt payments).

Selling all—or a portion—of its accounts receivables to a factor can help prevent a company that's cash strapped from defaulting on its loan payments with a creditor, such as a bank.

Although factoring is a relatively expensive form of financing, it can help a company improve its cash flow. Factors provide a valuable service to companies that operate in industries where it takes a long time to convert receivables to cash—and to companies that are growing rapidly and need cash to take advantage of new business opportunities.

A financial institution that provides factoring also benefits from these transactions because it can purchase uncollected receivables or assets at a discounted price (in exchange for being able to provide cash upfront).

Example of a Factor

Assume a factor has agreed to purchase an invoice of $1 million from Clothing Manufacturers Inc., representing outstanding receivables from Behemoth Co. The factor negotiates to discount the invoice by 4% and will advance $720,000 to Clothing Manufacturers Inc.

The balance of $240,000 will be forwarded by the factor to Clothing Manufacturers Inc. upon receipt of the $1 million accounts receivable invoice for Behemoth Co. The factor’s fees and commissions from this factoring deal amount to $40,000. The factor is more concerned with the creditworthiness of the invoiced party, Behemoth Co., than the company from which it has purchased the receivables.

The Bottom Line

A factor can act as a source of funding for a company. A factor is usually a financial institution; it agrees to pay a company the value of its outstanding invoices—less a discount for commission and fees. This practice is called factoring, or accounts receivable financing. The factoring company will set specific terms and conditions, depending on the risk involved in the transaction.

The practice of factoring is beneficial because it allows a company to boost its cash flow in the short term. For a factoring company, these transactions are beneficial because they earn a factoring fee for each transaction. Most factoring companies take between 1% and 5% of the total amount of the invoice value, but this amount can vary based on the factoring volume, client creditworthiness, business stability, and other considerations.