What is Accounts Receivable Factoring and How Does it Work?
Last Updated October 10, 2024
One of the most common issues facing small businesses are cash flow problems. Whether it’s caused by customers not paying on time or a reduction in sales, a lack of cash on hand can derail your company’s progress.
Thankfully, you have financing options to keep your business rolling, regardless of your business’s size, age, or creditworthiness.
Accounts receivable factoring is one of these financing options that can provide the cash you need. But what is AR factoring, how much does it cost, what are its qualification requirements and how does it work? Continue reading to find out.
What Is Accounts Receivable Factoring?
Accounts receivable factoring, also known as invoice factoring, is a type of business funding that helps companies cover cash deficits based on unpaid invoices. This type of financing is attractive because it can be structured to accommodate business needs, especially for smaller companies.
By financing existing invoices, a company can start on new jobs to ensure a constant stream of cash while still waiting for payment from previous clients. It alleviates the need to wait for customers to pay to take on new business, which is a common dilemma for new and growing businesses.
How Does Accounts Receivable Factoring Work?
Accounts receivable factoring is essentially a 5-step process:
- After a factoring agreement is signed, the factoring company (“factor”) assumes collection responsibilities for all of your future outstanding invoices and the debtor is to pay the factoring company moving forward, rather than your business.
- Once you invoice your customer, the invoice is then forwarded to your factor.
- Your factoring company then immediately advances the majority of the value of each invoice (typically up to 90%) to your business.
- Your factoring company tracks payment progress on each invoice, awaiting debtor payment.
- Once the debtor submits payment to the factoring company, any remaining funds that weren’t advanced are fully released to your business, minus the small factoring fee.
Just like that, you’ve completed AR factoring!
Digging Deeper into the Invoice Factoring Process
Since this is a unique financing method, you might feel intimidated by the AR factoring process. However, factoring is truly less involved than other financing options.
To better understand how it works, let’s take a look at an example from the beginning to the end of the process.
Alpha Business handles commercial roofing. To start an order, the company pays its crew and purchases all necessary supplies for the job. Once the team completes the job, the company waits for inspection and invoices the customer. It can take days for the inspection and another 90 days for the customer to pay.
In the meantime, Alpha Business has a new client requesting work. The new client wants Alpha Business to start immediately. However, the company hasn’t received payment from the first customer and lacks the money to start the new job.
As you can imagine, turning down work is problematic for several reasons. So, instead of passing on the new client and losing a valuable new client, Alpha Business pursues an agreement with an invoice factoring company.
Alpha Business submits the invoice from the job they completed to the lender. In return, the lender issues and advance, usually around 90% of the unpaid amount. This advance gives Alpha Business the money to cover payroll, purchase new materials, and accept the new job.
The customer submits payment for the invoice to the lender. Once the lender receives the full amount, they submit a rebate to Alpha Business. The rebate, or reserve amount, is the remaining 10% of the invoice amount minus the lender’s fees.
The Cost of Accounts Receivable Factoring
Lenders don’t offer advances to companies out of the goodness of their hearts. They collect fees for the service. In most cases, the fees range from 0.5% up to 5%, depending on several factors.
- Industry matters. The higher the risk of an industry, the higher the rate a lender charges the borrower.
- How much product is on the invoice? Lenders evaluate the volume of the invoice.
- What is your customer’s credit history? Do they have a solid history of timely payments?
- The age of the invoice matters, and lenders will consider how much time is left before the customer must pay. Most lenders want invoices due within 90 days.
- Is it recourse factoring or non-recourse factoring? Recourse factoring leads to lower rates, and we’ll explain why in a moment. Just know that non-recourse factoring costs a bit more.
Generally, the lower the risk involved, the lower the related fees. It’s important to understand what a lender considers, so you know what to expect before entering an agreement.
Keep in mind, there could be other fees involved, so it’s necessary to read over the agreement before signing. You don’t want to be surprised by a lower than expected rebate due to additional fees.
Recourse vs. Non-Recourse Accounts Receivable Factoring
One of the things lenders consider when determining invoice factoring rates is whether the transfer is with or without recourse. You must understand the difference between the two types before entering an agreement with a lender.
Most accounts receivable factoring falls under the recourse category because it is less risky for the lender. If a customer fails to pay an invoice in the set time frame, the lender can ask for recourse, or repayment of the amount they lent you.
When choosing the recourse factoring option, it’s in your best interest to only choose invoices from reliable customers. Borrowing against invoices with unstable clients sets you up for trouble down the line.
Non-recourse factoring is less risky for the borrower because they don’t have to return the advance if a customer fails to pay. However, there is more involved with non-recourse factoring because it doesn’t cover every failure to pay.
Most non-recourse factoring agreements include lists of clients they accept and circumstances they don’t cover, including breach of the agreement and disputed invoices. Further, the non-recourse provisions tend to apply only in situations where a customer cannot pay the invoice, like if they file for bankruptcy. Make sure that you’re also prepared to pay higher rates for taking on a non-recourse factoring agreement.
Benefits of Financing with Accounts Receivable Factoring Lenders
There are three big reasons to work with an accounts receivable factoring company, and they all revolve around growth potential in some capacity:
- Build your credit. Newer businesses or companies struggling with credit issues can use invoice factoring to establish a good credit history, provided you pay your lenders regularly and timely.
- Fast and easy financing. Accounts receivable factoring takes far less time and paperwork to secure the funds.
- It’s not a loan. Since it’s an advance based on the money you’re owed, it doesn’t show up as debt, and you don’t need collateral.
Reasons to Consider Accounts Receivable Factoring for Your Business
There are several reasons to pursue invoice factoring to bolster your cash on hand. From companies dealing with IRS issues to those hoping to cover payroll shortages, it’s a financing option that all business owners should understand.
You Need to Cover Shortfalls
Having additional funds on hand to cover emergencies, low traffic periods, or slow-paying customers is wonderful, but not always an option. If you’re sitting on outstanding invoices and wondering how to pay your staff, you may want to consider invoice factoring to stay on target.
You Can’t Secure Other Lending Options
Lack of credit history is a common pitfall for start-ups, but companies with poor credit histories can also struggle with traditional financing options. When traditional loans and independent investors aren’t options for a business, accounts receivable factoring can provide the cash they need.
Any businesses that can’t secure traditional funding options but have a solid product, and guaranteed money in the pipeline might consider leveraging their invoices. Not only does it provide cash fast without reliance on the company’s credit record, but it can also open doors to growth potential, including new clients.
Rapid Growth and High-Profits
Up and coming businesses can’t afford to turn down customers, especially when they’re on the cusp of greatness. When rapid growth happens, companies need enough capital to keep up with the demand so they can ride the wave of success and adequately scale their company.
Rapid growth companies with a significant number of sales can reach their full potential by using accounts receivable factoring. If the growth potential outweighs the lender’s fees, a company can accept new business instead of losing opportunities.
In-Summary: AR Factoring
Accounts receivable factoring has gained popularity for a good reason. Provided you can cover the small factoring fees and your customers can be relied upon to make the full payment to your lender, there’s not much risk involved.
If your company has several unpaid invoices and needs cash to sustain or grow, accounts receivable factoring could be just what you need. It’s a viable alternative financing option that provides fast cash, regardless of a company’s credit history.
Grey was previously the Director of Marketing for altLINE by The Southern Bank. With 10 years’ experience in digital marketing, content creation and small business operations, he helped businesses find the information they needed to make informed decisions about invoice factoring and A/R financing.
