Accounts Receivable Factoring

Accounts Receivable Factoring

Last Updated August 26, 2021

One of the most common issues facing any business are cash flow delays. Whether your customers aren’t paying on time or you’re facing massive growth opportunities, a lack of cash on hand can derail your company’s progress.

Thankfully, you have options to keep your business rolling. Accounts receivable factoring is one financing possibility that could give you the cash you need.

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 waiting for payment from previous clients. It alleviates some operational expenses for businesses to ensure continuity on many fronts.

How Does Accounts Receivable Factoring Work?

Invoice factoring is an alternative to traditional loans. It’s gaining popularity as a faster, easier financing option because it relies on existing invoices with customers who have not yet paid.

In this financing model, a factoring company, or lender, purchases unpaid invoices from a company for a portion of their worth (the advance). Once the customer submits payment, the lender sends the rest of the money (the rebate) minus fees to the company.

Digging Deeper into the Invoice Factoring Process

It may sound complicated, but invoice factoring is 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 80% 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 20% 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 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.

How Recourse Factoring Works

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.

The Basics of Non-Recourse Factoring

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.

Non-recourse factoring is riskier than it sounds, but it’s a good option in certain situations. Make sure that you understand the risks and prepare to pay higher rates for taking on a non-recourse factoring agreement.

When to Use Accounts Receivable Factoring

Accounts receivable factoring lenders generally deliver the cash within a day or two, so it’s appealing for companies that can’t wait for funds through traditional lending avenues. When used appropriately, invoice factoring can have a significant, positive impact on a business.

Benefits of Financing with Accounts Receivable Factoring Lenders

There are three big reasons to choose this financing option, 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 Invoice 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.

The Bottom Line

Accounts receivable factoring gained popularity for a good reason. Provided you can cover the fees and know that your customers can 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.