Receivables are among the most valuable assets of a company. When a company allows clients to take advantage of a product or service without requesting payment upfront and upon purchase, they gain receivables. In other words, clients become debtors and the amount they owe becomes the company’s asset. However, the risk is that the company might go on default in the long run when clients do not pay on time. Going beyond the limit of default leads to sudden bankruptcy.
Factoring is a transaction in financing designed to protect a company from this risk. In this transaction, a third party enters and buys the receivables at a discounted price. In this way, the seller or the company with accounts receivables from their clients will be safe from insolvency in case the client failed to pay or goes on a default. This is an excellent way to continue to finance a business.
It is a common mistake to relate factoring with invoice discounting, the latter of which is another transaction that involves accounts receivables. In contrast to factoring, receivables in invoice discounting are only used as collateral to a debt. In short, the third party does not buy them but expects ownership of them in case the company borrowing a security fund fails to pay.
Factoring is applicable to any form of businesses. Companies doing export benefit much from this financial transaction as they get rid of the high risk of repayment failure from their international clients, who might encounter economic depression due to political instability of sudden inflation in their currencies. Export factoring helps these companies to continue expanding their businesses without sure revenues.
Compared with forfeiting and other common business transactions, factoring involves three parties – the debtor (owing the receivables), the seller (expecting the receivables), and the factor (buying the receivables). All of these participants play vital role in keeping the business going. In export factoring, the factor does not give much importance to the trustworthiness of the seller but on the value of the receivables to buy.
The factor has all the right to the receivables once to agreement has been set. With a large discount placed on the sale, the factor can earn much when the receivables are repaid in time, although higher risk is involved in an export finance transaction wherein only a small probability of repayment is anticipated. The seller has no right to interfere with the mode of payment the factor set.