Factoring is a short term, non-bank financing of accounts-receivables. It is a financial transaction whereby a business sells its accounts receivable to a third party at a discount in exchange for immediate money with which to finance continued business.

Factoring allows you to raise finance based on the value of your outstanding invoices. Factoring also gives you the opportunity to outsource your sales ledger operations. The major advantage of factoring is that you receive the majority of the cash from debtors within 24 hours rather than a week or even longer.

Every factoring transaction includes three main principals: the advance, the reserve, and the fees. The parties involved are: the one who sells the receivable, the debtor, and the factor. 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.

Some advantages of factoring includes the following: Factoring can be an efficient way to minimize the cost and risk of doing business overseas; Reduce time and money you spend on debt collection; and maximizing cash flow.

Even though factoring has its advantages, it also has its disadvantages such as imposing constraints on the way to do business and or not meeting a customer’s desires or needs.

Factors make funds available, even when banks would not do so, because factors focus first on the credit worthiness of the debtor, the party who is obligated to pay the invoices for goods or services delivered by the seller.

While factoring is a great way to raise some equity for small firms, the same financial technique can be used to turn around a good business or make business mistakes that would make it impossible for the firm to work within the constraints of their bank covenants.

Sources:

http://www.businessdictionary.com/definition/factoring.html

http://www.bized.co.uk/learn/accounting/financial/sources/factor.htm