Factoring, also known as invoice discounting or receivables factoring, involves one company purchasing a debt or invoice from another company at a discounted price. The buyer profits by collecting the full amount owed, while the seller receives working capital. However, factoring can place the debtor under significant financial pressure, and it’s important to review each account before proceeding.
Factoring goes by many names, including invoice discounting, receivables factoring, and debtor financing. In simple terms, factoring is a practice where one company purchases a debt or invoice from another company. It refers to the acquisition of receivables, which are discounted to enable the acquirer to make a profit upon collection of the funds owed. Factoring transfers ownership of those accounts to another party who works vigorously to collect the debt.
While factoring may allow the responsible party to be relieved of debt for less than the total amount, it is generally designed to be more beneficial to the factor, or the new owner and seller of the account than the debtor. The seller receives working capital, while the buyer is able to make a profit by buying a bill substantially less than it’s worth and then collecting it. Factoring allows the buyer to purchase those accounts for approximately 25% less than they are actually worth.
The steward takes full responsibility for debt collection. The factor is required to pay additional taxes, usually a small percentage, once collection efforts prove effective. The new account owner can offer the responsible person or entity a small discount on the outstanding debt. Other arrangements are sometimes made, where the debt is considered paid in full if a lump sum repayment is made under certain terms and conditions. Unfortunately, in some cases, factoring can place the indebted consumer or company under significant financial pressure, as is the case with debt consolidation.
For example, if a person participates in a debt consolidation program and a creditor engages in factoring, the entity purchasing the account may not be bound by the program agreement with the original creditor. The factor can require a large sum to consider the checking account and can increase the interest rates and the monthly payment amount. This form of factoring can prove profitable in some cases, but can backfire in others. The debtor may have no choice but to file for bankruptcy because they simply cannot afford the inflated interest rates and payment amounts. In most cases, factoring is a profitable venture, but it’s a good idea to review each account on an individual basis before deciding how to proceed.
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