In finance, what is meant by factoring of Accounts Receivable?

Introduction / Context:
Factoring is a specialised financing technique often used by companies to improve cash flow. Instead of waiting for customers to pay their invoices, a business can sell those invoices to a third party called a factor. This concept appears frequently in accounting, corporate finance, and banking interviews. The question checks whether you understand the basic idea and purpose of factoring in connection with Accounts Receivable.

Given Data / Assumptions:

• The business has Accounts Receivable arising from credit sales to customers.
• It needs faster access to cash and does not want to wait until each customer pays on due dates.
• A specialised finance company, the factor, is willing to buy these receivables at a discount.
• The factor may also provide additional services such as collections and credit risk assessment.

Concept / Approach:
Factoring is the sale of receivables, not a simple loan. The company sells its invoices to the factor, who pays an immediate advance, usually a percentage of the invoice value, and may pay the balance minus fees when customers actually pay. The discount and fees represent the factor's compensation for taking over the collection risk and providing early liquidity. Factoring can be done with or without recourse; in with recourse factoring, the seller retains some risk if customers do not pay, whereas in without recourse factoring, the factor bears the credit risk.

Step-by-Step Solution:
Step 1: Identify that the transaction involves Accounts Receivable and a specialised finance company, not a normal interest calculation or company split. Step 2: Recognise that the business receives immediate cash from the factor by selling its invoices. Step 3: Understand that the factor pays less than the total face value of the receivables, reflecting a discount and service fee. Step 4: Note that the factor typically takes over collection efforts and may also assume credit risk, depending on the contract. Step 5: Choose the option that accurately describes factoring as a sale of receivables at a discount to obtain immediate cash.

Verification / Alternative check:
Imagine a company with Rs 10,00,000 in invoices due in 60 days. Instead of waiting, it sells those invoices to a factor for, say, Rs 9,50,000 now. The factor then collects the full Rs 10,00,000 from customers at maturity, earning Rs 50,000 less any additional costs. From the company's perspective, the benefit is improved cash flow and reduced collection effort. This practical example matches the description in the correct option.

Why Other Options Are Wrong:
Calculating simple interest by multiplying principal and rate is an interest computation method, not factoring. A legal process of winding up an insolvent company is liquidation, not factoring. Splitting a company into separate units may be called demerger or restructuring, and is unrelated to receivable financing.

Common Pitfalls:
Learners sometimes confuse factoring with bank overdrafts or traditional loans, where receivables are used as collateral but are not sold. Others may think that factoring always transfers all risk, ignoring the distinction between with recourse and without recourse arrangements. It is important to remember that in factoring, receivables are generally purchased by the factor, making it more like a sale of assets than a simple borrowing.

Final Answer:
Factoring is a financial arrangement in which a business sells its accounts receivable to a factor (specialised finance company) at a discount in exchange for immediate cash.