Factoring is a financial transaction where a business sells its accounts receivable to a third party called a factor in exchange for immediate cash. This differs from a bank loan in that it is based on the value of the receivables rather than the firm's creditworthiness, and it involves three parties rather than two. Factoring allows firms to obtain cash quickly to meet obligations and support growth, while reducing the amount of cash they need to hold on hand. The extent to which factoring is used depends on the variability of a firm's cash flow and the tradeoff between returns from investing proceeds and costs of factoring receivables.

1. Factoring is a financial transaction whereby a business job sells its accounts receivable (i.e.,
invoices) to a third party (called a factor) at a discount in exchange for immediate money
with which to finance continued business. Factoring differs from a bank loan in three main
ways. First, the emphasis is on the value of the receivables (essentially a financial asset),[1][2]
not the firm’s credit worthiness. Secondly, factoring is not a loan – it is the purchase of a
financial asset (the receivable). Finally, a bank loan involves two parties whereas factoring
involves three.
It is different from forfaiting only in the sense that forfaiting is a transaction-based operation
involving exporters in which the firm sells one of its transactions,[3] while factoring is a
Financial Transaction that involves the Sale of any portion of the firm's Receivables.[2][1]
Factoring is a word often misused synonymously with invoice discounting[citation needed] -
factoring is the sale of receivables, whereas invoice discounting is borrowing where the
receivable is used as collateral.[4]
The three parties directly involved are: the one who sells the receivable, the debtor, and the
factor. The receivable is essentially a financial asset associated with the debtor's liability to
pay money owed to the seller (usually for work performed or goods sold). The seller then
sells one or more of its invoices (the receivables) at a discount to the third party, the
specialized financial organization (aka the factor), to obtain cash. The sale of the receivables
essentially transfers ownership of the receivables to the factor, indicating the factor obtains
all of the rights and risks associated with the receivables.[2][1] Accordingly, the factor obtains
the right to receive the payments made by the debtor for the invoice amount and must bear
the loss if the debtor does not pay the invoice amount. Usually, the account debtor is notified
of the sale of the receivable, and the factor bills the debtor and makes all collections. Critical
to the factoring transaction, the seller should never collect the payments made by the account
debtor, otherwise the seller could potentially risk further advances from the factor. There are
three principal parts to the factoring transaction; a.) the advance, a percentage of the invoice
face value that is paid to the seller upon submission, b.) the reserve, the remainder of the total
invoice amount held until the payment by the account debtor is made and c.) the fee, the cost
associated with the transaction which is deducted from the reserve prior to it being paid back
the seller. Sometimes the factor charges the seller a service charge, as well as interest based
on how long the factor must wait to receive payments from the debtor. [5] The factor also
estimates the amount that may not be collected due to non-payment, and makes
accommodation for this when determining the amount that will be given to the seller. The
factor's overall profit is the difference between the price it paid for the invoice and the money
received from the debtor, less the amount lost due to non-payment.[2]
In the United States, under the Generally Accepted Accounting Principles receivables are
considered sold when the buyer has "no recourse,"[6] or when the financial transaction is
substantially a transfer of all of the rights associated with the receivables and the seller's
monetary liability under any "recourse" provision is well established at the time of the sale.[7]
Otherwise, the financial transaction is treated as a loan, with the receivables used as
collateral.

2. Reason
Factoring is a method used by a firm to obtain cash when the available cash balance held by
the firm is insufficient to meet current obligations and accommodate its other cash needs,
such as new orders or contracts. The use of factoring to obtain the cash needed to
accommodate the firm’s immediate Cash needs will allow the firm to maintain a smaller
ongoing Cash Balance. By reducing the size of its cash balances, more money is made
available for investment in the firm’s growth. A company sells its invoices at a discount to
their face value when it calculates that it will be better off using the proceeds to bolster its
own growth than it would be by effectively functioning as its "customer's bank."[8]
Accordingly, Factoring occurs when the rate of return on the proceeds invested in production
exceed the costs associated with Factoring the Receivables. Therefore, the trade off between
the return the firm earns on investment in production and the cost of utilizing a Factor is
crucial in determining both the extent Factoring is used and the quantity of Cash the firm
holds on hand.
Many businesses have Cash Flow that varies. A business might have a relatively large Cash
Flow in one period, and might have a relatively small Cash Flow in another period. Because
of this, firms find it necessary to both maintain a Cash Balance on hand, and to use such
methods as Factoring, in order to enable them to cover their Short Term cash needs in those
periods in which these needs exceed the Cash Flow. Each business must then decide how
much it wants to depend on Factoring to cover short falls in Cash, and how large a Cash
Balance it wants to maintain in order to ensure it has enough Cash on hand during periods of
low Cash Flow.
Generally, the variability in the cash flow will determine the size of the Cash Balance a
business will tend to hold as well as the extent it may have to depend on such financial
mechanisms as Factoring. Cash flow variability is directly related to 2 factors:
1. The extent Cash Flow can change,
2. The length of time Cash Flow can remain at a below average level.
If cash flow can decrease drastically, the business will find it needs large amounts of cash
from either existing Cash Balances or from a Factor to cover its obligations during this period
of time. Likewise, the longer a relatively low cash flow can last, the more cash is needed
from another source (Cash Balances or a Factor) to cover its obligations during this time. As
indicated, the business must balance the opportunity cost of losing a return on the Cash that it
could otherwise invest, against the costs associated with the use of Factoring.
The Cash Balance a business holds is essentially a Demand for Transactions Money. As
stated, the size of the Cash Balance the firm decides to hold is directly related to its
unwillingness to pay the costs necessary to use a Factor to finance its short term cash needs.
The problem faced by the business in deciding the size of the Cash Balance it wants to
maintain on hand is similar to the decision it faces when it decides how much physical
inventory it should maintain. In this situation, the business must balance the cost of obtaining
cash proceeds from a Factor against the opportunity cost of the losing the Rate of Return it
earns on investment within its business.[9] The solution to the problem is:

3. [10]
where
CB is the Cash Balance
nCF is the average Negative Cash Flow in a given period
i is the [Discount Rate] that cover the Factoring Costs
r is the rate of return on the firm’s assets[11]