Question

A firm does not have resources to collect on its accounts receivables and needs cash to run its business. Which method of short-term financing (pledging or factoring accounts receivables) would you recommend and why?

Answer 1

Factoring accounts receivables has become very popular among the big companies to finance its working capital requirements. First of all let's understand what do we mean by factoring accounts receivables.

Under factoring the company "factors" its accounts receivables with the other party, i.e., it sells its accounts receivable to another party and receives cash in advance against the same after deducting a small percentage of the amount of accounts receivables. The main purpose of factoring is to meet the working capital requirements of the company, i.e., instead of receiving the monay, say after a period of 60 or 90 days as per the credit terms of the customer, the company can receive the money in advance by paying a small part of the total amount of accounts receivables which is usually around 2-5%.

Some of the main advantages of factoring include:

1. As compared to other sources for short-term financing, this source is usually much easier to get. A lot of banks worldwide are providing this facility to its customers.

2. Amount of this short-term financing is completely dependent upon the company itself. Normally companies face the difficulty of obtaining adequate amount of short-term financing but in the case of factoring, the amount you get will increase with the amount of accounts receivables.

3. The most important advantage is that it provides the company with immediate cash, i.e., it helps you meet any outstanding payment of vendors and will also help you grab any short-term investment opportunity.

4. Another advantage is that it is a good option for both big and small companies.