Bank factoring occurs when a business sells some or all of its accounts receivable to a bank in exchange for a cash payout. The payout usually represents a large percentage of the amount due in the accounts receivable, which are payments due to the business from debtors. After the payout, the bank then takes on the role of collecting the accounts receivable, and it pays off the remaining amount due, minus discount fees, to the business once all accounts are collected. This process of bank factoring allows the bank to make a profit and the business to collect working capital at a much faster rate.
Many businesses allow those who purchase their goods and services to do so on credit, which means that the buyer gets the goods or services purchased before offering payment, which can come at a significantly later date. Until this payment is made, businesses have essentially yielded their product without anything to show for it in terms of capital. This can be problematic when it comes time for a business to pay its own bills. Bank factoring allows the business to quickly get its hands on the capital from its sales.
The process of bank factoring begins with the business selling its accounts receivable to a bank, which then acts as the factor in the transaction. At that point, the bank immediately gives the business a lump sum payment that represents a large portion of the amount the business is owed in the accounts receivable, usually around 90 percent. In essence, the bank then becomes the accounts receivable department for the business, and it goes about collecting the payments from debtors.
Once those payments are collected, the bank then returns the remaining money owed the business from the accounts receivable, but only after taking out its own discount fees. These fees are determined at the start of the bank factoring agreement. The bank usually bases its fees on the amount of money owed the business, the amount of time given the debtors to pay, and the credit status of those debtors.
Although these discount fees might seem like a detriment, they are a relatively small amount and can be offset by the amount that the business saves in clerical tasks and paperwork when having to collect the payments themselves. Bank factoring is especially useful for small businesses that may not yet have the capital to show for all of their enterprises. Bigger businesses may also consider factoring if they face any kind of sudden cash crunch.