Factoring, debtor financing or receivables factoring is one of the most common trade finance solutions available to customers in the banking and financial services industry. In this type of financing, a company buys the invoice or debt from another company. In simple terms, factoring allows a third party, other than the original creditor to collect a debt and make a profit on it.

Here is how it works (simplified)-

Company A needs a 10,000 pounds loan for which it approaches company B.

Company B suggests that it would give the loan for three months and take 1000 pounds as interest. Company A agrees.

However, before the three months are over, Company B needs money. It already has 11,000 pounds payment incoming from Company A. So it goes to Company C and asks it to lend them 10,000 pounds on the basis of the 11,000-pound loan given to A.

Company C agrees to give the loan to Company B.

When the three months are over, Company A (the original debtor) will pay the loan to Company C (the new creditor). A pays the original amount of 10,000 pounds + 1,000 pounds interest. Company C thus makes a profit of 1,000 pounds.

This is a highly simplified version of what happens in factoring. Because this process is most commonly witnessed in trade finance, it is often called invoice discounting as well. In our example, we saw how Company B bailed out of the role of the creditor, sold the debt to a third party which will become the new owner of the debt.

Why is factoring popular?

Factoring allows traders to continue their cash flow while operating business. Most businesses need credit to survive, and even invoices may take up to 60 days (sometimes more) to be paid. For traders, depending solely on invoices will become a problem as they will be unable to maintain their businesses. Factoring offers an easy solution. It helps in getting fast invoice payments to the business owners or traders and lets another company take care of invoice collection.

In general, the payments to be made by the debtor are guaranteed by their banks which helps the debt buyers to rest assured of their payments. In the UK, the agreement between the original creditor and the debt buyer is usually confidential. However, in some countries, the debtor may be notified about the change. The debt buyer can also offer a discount to the debtor if he so pleases. The debt buyer is called ‘factor’ which leads to the term factoring.

Factoring isn’t necessarily a one-time event. Companies specializing in factoring and trade finance may open a line of credit for a business on the basis of their debts and invoices/receivables. The business simply needs to forward the invoices to the factoring company on a regular basis and get paid. The fees paid to the factoring company is decided by the local laws, the company policies and the sometimes the expected bad debt on an invoice.