Factoring (also known as accounts receivable financing) is a form of asset based lending that is used by a wide variety of companies in many different industries. Factoring is used by companies ranging in size from a single employee to Fortune 500 companies. In short, factoring allows companies to sell their accounts receivable to a factor (company that buys receivables) in an effort to improve their short-term cash balance. Below is a diagram that shows the factoring process in detail.
Different types of businesses use factoring in different ways. Some use factoring to avoid bankruptcy, while others use factoring to help finance large orders that their company is not prepared to fulfill. Below is another example factoring can be used:
Factoring is also used by businesses that grow so quickly they surpass the lending ability of their traditional bank. In these cases factoring companies can step in to provide the additional capital.
This example uses ABC Energy, a small, but rapidly growing company in Virginia that has developed a solar panel solution that dramatically decreases the energy savings payback period. Home Depot has taken a serious interest in this product and has decided to put in order for 80,000 units. This amount far exceeds anything the company has produced in the past. ABC executives are thrilled with the size of the order, but are worried about the capital needed to fill it. Filling the order would leave their cash balances at very low levels and they still have other orders coming in. The company would be in a very difficult position until they receive payment from Home Depot.
ABC Energy decides to approach a factoring company to help finance the fulfillment of the order. The factor sees little risk in collection from Home Depot. Therefore, the factor purchases ABC Energy's accounts receivable. This allows ABC Energy to easily fill the Home Depot order as well as the rest of their orders while maintaining a healthy cash balance.