The Mechanics of a Factoring Transaction
For businesses that have not used factoring in the past, the concept of entering into a financial
transaction that is mechanically unknown to the principals can be daunting. However, factoring is quite
simple and intuitive. Factoring is the sale of invoices (accounts receivable) for immediate cash
between two willing parties. Factoring differs from a traditional bank credit facility due to the sale
aspect – the obligation to collect the amount due on the receivable or invoice is the duty of the factor,
not the business that generated the receivable.
A traditional factoring transaction has the following components:
1) Company A sells and delivers widgets to Buyer ( also known as an “account debtor”) and
presents it with an invoice
2) Buyer agrees to pay the invoice 60 days after widget delivery
3) Company A must pay the widget manufacturer in 10 days
4) Factor buys the invoice and Buyer’s promise to pay from Company A at a slight discount plus a
reserve. Company A uses proceeds to pay manufacturer or for general corporate purposes
5) In 60 days, the buyer pays the factor all amounts due under the invoice and the factor remits to
Company A the reserve less any outstanding fees and expenses
Most factoring transactions are constructed as revolving facilities. As such, the factor will allow the
client (Customer A in the diagram) to sell as many invoices to the factor as long as the aggregate
amount of unpaid invoices purchased by the factor does not exceed an agreed-upon level (the
maximum facility amount). Some factoring programs are established so that the client will only sell one
or two (usually large) invoices in one-off transactions, but that is the exception, not the rule. This type of
factoring is known as “spot factoring.”
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There are two stages of cash transfer from the factor to the client. An explanation of each is provided
below:
1) Stage One: Presentation of an Invoice – Upon sale of goods and services to the buyer or account
debtor, clients will submit invoices to a factor for funding. The factor will review the invoice to
ensure that the “Remit To:” information clearly identifies the factor’s “lockbox” as the location to
send the payment (a lockbox is a secure location, usually a bank, where payments are received,
processed and posted). The payee must also be listed as the factor. All invoice payments must be
made to the factor’s lockbox because the factor has purchased that receivable and is responsible
for collecting and receiving it. This also greatly reduces the need for the client to maintain a
collections staff. The initial payment to the client during this stage ranges from 70% - 90% of the
invoice amount. The remaining balance, called the reserve, is returned during stage two.
2) Stage Two: Receipt of the invoice payment from account debtor to the factor – Once the
account debtor remits the invoice payment to the designated lockbox, the factor will send the
reserve amount (the 10% - 30% remaining as illustrated in the example above) back to the client.
The reserve amount will be reduced to cover the fees associated with use of the factoring facility;
timing is solely determined by the account debtor’s payment.
Because factoring is a sale transaction and not a loan, the client does not owe the factor any principal
or interest. The cost to use the facility is deducted from the final reserve payment.