Factoring represents a sale of accounts receivable to a financial institution, which acts as a factor. This may
be a bank, or an independent factoring broker. There are three parties to this transaction: a client company
(a producer that has provided services or produced goods, and issued invoices to its debtors, who need to
pay invoices to the company under certain conditions); a debtor (the company that ought to pay the invoice
to the producer in due time); and a factor that facilitates the transaction through buying the invoice from the
client, and finances the amount over an agreed period.
Simple Illustration
The factor purchases £100 from its client under a factoring contract. The client company (borrower) receives,
from the factor, 70% of the value of the invoice minus interest and service fees, and minus a factoring
commission of, say, 2%. The client receives the remaining 30% upon receiving the payment from its
customer. The amount of £30 serves as a reserve amount, and is kept by the factor until the invoice is paid.
At the beginning of the transaction, the factor advances £68 and acquires ownership of the whole receivable.
When the invoice is paid in 31 days, the factor sends £30 to the client on day 31. The size of the reserve
depends on the perceived risk of the client. There will be an additional cost, which will be the interest on
the outstanding balance of receivables. The interest can be deducted at the beginning, at the same time as
factoring the commission.
The client company pays a commission fee for the factoring service to the factor, as well as interest for the
period of financing. The factor bears the risk of non-paying customers. The factor buys the receivable at a
discount, which ranges from 0.35% to 4%. The interest for factoring is usually 1.5 to 3 percentage points
above the base rate, reflecting the overall risk of the transaction, as well as current market conditions. The
rates are roughly equivalent to bank overdraft rates, and can occasionally be better.
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