Last Updated October 5, 2023
Does your business need financing to expand or improve cash flow? If so, invoice factoring and accounts receivable financing are options worth exploring.
A tremendous amount of information exists about these two financing solutions, but after researching, you might be left feeling confused. Many sources use the terms factoring and accounts receivable (AR) financing interchangeably, or you might find different definitions from different sources. The goal of this piece is to provide clarity regarding A/R financing vs. factoring by explaining how each solution works, discussing similarities and differences, and helping you decide which is the better fit for your business.
So, how does factoring differ from accounts receivable financing? Let’s discuss – first, invoice factoring.
What is Invoice Factoring?
Invoice factoring is an alternative financing solution where outstanding invoices are converted into immediate cash. Factoring serves as a reliable alternative to a line of credit and other traditional bank loans, helping businesses that:
- Deal with slow-paying customers
- Experience seasonality or are undergoing dynamic change
- Want to expand or are in the process of rapid growth
- Want to launch as a start-up
How Invoice Factoring Works
In factoring, a business sells its invoices to a third-party factor (factoring company). The business presents a schedule to the factoring company detailing which invoices among their accounts receivable they’re planning on factoring. Then, the factoring company advances a predetermined percentage (typically 80-90%) of each total invoice value into the business’s checking account.
It’s important to note that by this time, your business should have already notified your customer(s) that going forward, they will forward all payments to the factoring company, not your business. Therefore, once your customer pays the invoice to your factor, the factor can simply pay out the remaining invoice amount to your business (minus a small factoring fee, typically 0.5 to 3.75%).
Thus, invoice factoring is an ideal financing solution for a business not wanting to wait 30,60 or 90 days for their receivables to roll in.
What is AR Financing?
Accounts receivable (AR) financing also uses outstanding invoices to fund growth. Like invoice factoring, AR financing serves as another alternative to a traditional line of credit and helps businesses who:
- Expect (or are undergoing) steady growth and expansion
- Experience seasonality or another form of dynamic change
- May not be in a position for a traditional bank loan, but working towards it
If the small details confuse you, just remember this: if your business is a good fit for AR financing, you’re likely a good fit for invoice factoring (or vice versa).
How AR Financing Works
In accounts receivable financing, a business sells all of its invoices to establish a borrowing base. Similar to a traditional line of credit, the receivables line operates as a revolver. So, in AR financing the receivables are pooled.
While this is different from invoice factoring (where receivables are not pooled) there will be a minimum monthly fee for both factoring and AR financing. Therefore, if you’re utilizing AR financing, and you choose not to pull from your pool during a certain month, you’ll still be charged that minimum monthly fee.
What Does AR Stand for in AR Financing?
AR in AR financing stands for “accounts receivable”, referring to the money that clients owe you for goods or services received but have yet to be paid. Some clients have long payment cycles, which disrupt cash flow and make maintaining your business more challenging, leading to a need for financing.
Accounts Receivable Financing vs. Factoring
The main difference between invoice factoring and AR financing lies in the underwriting criteria of the deal structures. More specifically, the key differences between accounts receivable financing and factoring lie in how the fees are calculated and how a business borrows against their invoices. Let’s explain.
A/R financing provides you a pool of funds to borrow against your invoices, while factoring is the process of selling an invoice, receiving a cash advance, and ultimately paying a small fee on each individual invoice once your customer pays and the remaining value of the invoice is funded to your business.
With A/R financing, you’re charged a fixed monthly fee. No matter how much you pull from your credit facility for a given month, say $2,000 vs. $10,000, you’ll end up paying the same fee. It works more like asset-based lending with traditional interest rates and can get a bit more complicated than standard factoring.
With factoring, the fee is based off of the face value of each invoice (typically 0.5% to 3.75%).
Furthermore, while businesses with subpar credit can look to both of these financing options as great alternatives, there is a tad more leniency with factoring regarding creditworthiness during the application process. That said, the most important aspect of the background checks for both AR financing and factoring remains the credit history of your customers. Factors want to ensure customers are reliable to pay their invoices.
However, while factoring offers greater flexibility, these options are overall very similar. If you’re a fit for one, you’re highly likely a fit for the other.
Why Do Companies Use Invoice Factoring?
Invoice factoring is an ideal financing solution for a small business owner who does not want to wait up to 30, 60 or 90 days for their receivables to roll in. These long payment terms can disrupt cash flow, especially for small businesses, which is why factoring is so popular for start-ups and new businesses.
Gone are the days of waiting weeks to months for customers to pay and having to figure out how to politely ask for payment over email. Instead, you can get cash within 1 to 2 business days to keep your cash flow positive.
Which Option is Best for Your Company?
Both invoice factoring and AR financing benefit businesses by providing funds in advance of collection. When cash flow timing matters most, both of these working capital financing options quickly put money into the business. In addition, both offer professional credit services and receivables management.
The main difference between invoice factoring and AR financing lies in the underwriting criteria of the deal structures. While factoring offers greater flexibility, AR financing does have a touch more strictness around the credit profile.
Good fit for invoice factoring?
If your business matches some or all of these characteristics, you may be a fit:
- B2B business
- Long payment terms
- Fair to poor credit history
- Limited operating history
- Few/no hard assets to borrow against
Good fit for AR financing?
These characteristics are largely the same, with the main difference being credit + invoice size:
- B2B business
- Large outstanding invoices
- Strong outstanding receivables
- Fair to above average credit history
- Limited operating history
- Few/no hard assets to borrow against
How do the fees compare?
The fees associated with accounts receivable financing and invoice factoring vary, so it’s difficult to compare. Fees are determined based on various factors such as your customer’s creditworthiness, the age and size of your business, length of customer payment terms, and how much you’ll be factoring per month.
For more information, read our article on factoring rates and fees.
Answering Your Questions
Here at altLINE, transparency defines our approach. If you’re like most of our customers, getting straight forward answers and understanding the detailed financial implications to your business are key factors in your financing decision. We explain and clarify along the way so you aren’t left wondering what you signed up for. Researching partners and need a question answered? Contact us and get your questions answered today.
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.
