Factoring is a financial transaction whereby a business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount. In "advance" factoring, the factor provides financing to the seller of the accounts in the form of a cash "advance," often 70-85% of the purchase price of the accounts, with the balance of the purchase price being paid, net of the factor's discount fee (commission) and other charges, upon collection from the account client. In "maturity" factoring, the factor makes no advance on the purchased accounts; rather, the purchase price is paid on or about the average maturity date of the accounts being purchased in the batch. Factoring differs from a bank loan in several ways. The emphasis is on the value of the receivables (essentially a financial asset), whereas a bank focuses more on the value of the borrower's total assets, and often also considers, in underwriting the loan, the value attributable to non-accounts collateral owned by the borrower. Such collateral includes inventory, equipment, and real property, [1] [2] that is, a bank loan issuer looks beyond the credit-worthiness of the firm's accounts receivables and of the account debtors (obligors) thereon. Secondly, factoring is not a loan – it is the purchase of a financial asset (the receivable). Third, a nonrecourse factor assumes the "credit risk” that a purchased account will not collect due solely to the financial inability of account debtor to pay. In the United States, if the factor does not assume credit risk on the purchased accounts, in most cases a court will recharacterize the transaction as a secured loan.

It is different from forfeiting in the sense that forfeiting 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.[1][2]

Factoring is a word often misused synonymously with invoice discounting, known as "Receivables Assignment" in American Accounting ("Generally Accepted Accounting Principles"/"GAAP" propagated by FASB)[2] - factoring is the sale of receivables, whereas invoice discounting is borrowing where the receivable is used as collateral.[2] However, in some other markets, such as the UK, invoice discounting is considered to be a form of factoring involving the assignment of receivables and is included in official factoring statistics.[4] It is therefore not considered to be borrowing in the UK. In the UK the arrangement is usually confidential in that the debtor is not notified of the assignment of the receivable and the seller of the receivable collects the debt on behalf of the factor.

The three parties directly involved are: the one who sells the receivable, the debtor (the account debtor, or customer of the seller), 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), often, in advance factoring, 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 associated with the receivables. [1][2] Accordingly, the factor obtains the right to receive the payments made by the debtor for the invoice amount and, in nonrecourse factoring, must bear the loss if the account debtor does not pay the invoice amount due solely to his or its financial inability to pay. Usually, the account debtor is notified of the sale of the receivable, and the factor bills the debtor and makes all collections; however, non-notification factoring, where the client (seller) collects the accounts sold to the factor, as agent of the factor, also occurs. There are three principal parts to "advance" factoring transaction; (a) the advance, a percentage of the invoice face value that is paid to the seller at the time of sale, (b) the reserve, the remainder of the purchase price held until the payment by the account debtor is made and (c) the discount fee, the cost associated with the transaction which is deducted from the reserve, along with other expenses, upon collection, before the reserve is disbursed to the factor's client. Sometimes the factor charges the seller (the factor's "client") both a discount fee, for the factor's assumption of credit risk and other services provided, as well as interest on the factor's advance, based on how long the advance, often treated as a loan (repaid by set-off against the factor's purchase obligation, when the account is collected), is outstanding.[5] The factor also estimates the amount that may not be collected due to non-payment, and makes accommodation for this in pricing, when determining the purchase price to be paid 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, under Statement of Financial Accounting Standards No. 140, when the buyer has "no recourse,".[6] Moreover, to treat the transaction as a sale under GAAP, the seller's monetary liability under any "recourse" provision must be readily estimated at the time of the sale. Otherwise, the financial transaction is treated as a loan, with the receivables used as collateral.