What is a Factor?
A factor is a financial institution that purchases receivables from a company.
How Does a Factor Work?
Let's say Company XYZ sells widgets. It has about $1 million in receivables from customers who have not paid for their widgets.
Company XYZ needs cash right away because it is trying to finish building a new factory. It calls a factor, which purchases the receivables for $750,000. In the deal, Company XYZ gets $750,000 right away, and the factor gets the right to all the money from the receivables ($1 million). The factor then assumes the risk of customers paying late or not at all.
Why Does a Factor Matter?
Factors and factoring can be complicated, but the basic idea is that companies can trade cash flows later for cash flows now, which is useful for companies that need cash right away. It can also be expensive, as the example shows (Company XYZ gave up $250,000 of its receivables for the deal).
Because factors assume the risk of collecting the receivables, they are choosy about which companies they work with and the creditworthiness of the companies' customers.