Factoring is an arrangement under which a business house outsources the collection of its book debts to an external entity (a factor) against the payment of a fee.
Business houses sell goods and services both in cash and on credit. Under credit sales, a credit period is offered to the buyer within which period the payment has to be made to the seller.
Unlike cash sales, however, credit sales incorporates certain inherent risk. Often a buyer will default in his payment and the considerable time and efforts have to be spent to administer and ensure the ultimate collection of such debts. Worst still a buyer will not pay at all. Delayed collection/non-collection of book debts strains the resources of the firm and hamper its day to day activities.
Under such a backdrop a company may outsource the administration and collection of its book debts to an external agency in exchange of a fee. The factor will advance a certain amount of the credit sales invoices upfront to the company. The debts, as and when they fall due, will be collected by the factor. The collections made will be periodically handed over to the owner/seller after adjustment of the ‘factoring fee’ and the amount advanced.
1. Factoring with recourse: Under a factoring with recourse arrangement, the risk of bad-debts is borne by the owner/seller.
2. Factoring sans recourse: Under a factoring sans recourse arrangement, the risk of bad-debts is borne by the factor. The factoring fees under such an arrangement is generally high.