As a small business trying to thrive in an unpredictable economy, business owners often need to use alternative financing tools to keep cash flow steady, such as inventory financing or Pay-it-Later. Another finance tool that is used is accounts receivable factoring, or A/R factoring.
This article will walk you through how A/R factoring works, the different kinds available, and which businesses are most likely to benefit from this approach.
Accounts receivable factoring, or A/R factoring, is a form of financing where businesses sell their invoices to a third-party factoring company at a discount. The company then advances a percentage of the invoice value to the business, typically 70% to 90%, and, once the business’ customer pays the invoice, the factoring company pays the business the balance, minus fees.
For example, a 90% advance rate on a $10,000 invoice would mean the factoring company sends the business $9,000 upfront, then remits the difference when the invoice is collected from the business’ customer at the end of the invoice period, less a handling fee. A/R factoring fees generally fall between 1 and 6 percent of the total invoice. In the above example, if the fee is 3%, then the factoring company would remit $700 to the business once the customer has paid the invoice.
If you’re concerned about how using A/R factoring might affect your balance sheet, don’t be. The accounts receivable would be listed as a current asset, as it typically can be converted into cash within a year. If the amount converts into cash in a period of more than one year, it is instead recorded as a long term asset.
There are several common scenarios in which businesses select A/R factoring as a financing option:
- Long or unpredictable collection times: Some industries, such as logistics, have extended payment terms, which can be challenging for small businesses. Factoring can provide immediate cash to keep capital stable between payments. Seasonal fluctuations: Businesses that experience fluctuations in revenue throughout the year use A/R factoring to help keep cash flow robust during slow seasons.
- Short credit histories: Small businesses with limited credit history or poor credit scores use accounts receivable factoring as a way to access financing without their credit history being a concern.
- Uneven collections and disbursements: Companies such as temporary staffing agencies pay employees on a bi-weekly basis, but their invoices are settled monthly. A/R factoring helps these companies cover their overhead in the interim.
- Dependency on other parties: In the construction industry, sub-contractors only get paid once the project owner settles their invoice with the lead contractor. A/R factoring can provide immediate payment to sub-contractors, allowing them to meet their expenses and keep capital flowing into their business.
- Recourse factoring: If the factoring company doesn’t receive repayment from the business’ customer, the business is required to repurchase the unpaid invoice from the factoring company. The handling fees are usually lower than non-recourse factoring since the business assumes more risk.
- Non-Recourse factoring: The factoring company bears the loss if the factored invoice is not settled. Handling fees are usually higher because the factoring company assumes more risk.
A/R factoring possesses several key differences when compared to more traditional financing options like bank loans, line of credit, or credit cards:
- Fast approval process: Factoring companies can generally approve a business within several days, while a bank loan can take weeks or even several months.
- Customer credit history: Bank loans and lines of credit will need a good credit score to qualify a business for a loan. Factoring companies, however, base their approval on the credit history of the business’ customers rather than on the business itself.
- Collateral-free: Bank loans will almost certainly require collateral, whereas factoring companies do not, since the financing is secured by the accounts receivable.
- Low interest charges: Banks and credit cards generally come with higher interest rates. Factoring companies, meanwhile, charge fees rather than collect interest, with the rate often being based on the business’s credit history.
- Flexible repayment terms: Compared to banks or credit cards, which typically require fixed monthly payments, factoring companies offer more flexible repayment terms.
There are, however, some disadvantages to A/R factoring compared to other tools such as:
- Higher fees
- Loss of control over the the accounts receivable
- Risk to customer relationships
- Possibility of fraud or disputes
As outlined above, A/R factoring carries both advantages and disadvantages, and businesses will need to make an assessment of their needs to determine whether it is the right option. This requires looking at your cash flow needs, evaluating whether the cost is worth it, and examining how this method would impact your relationships with customers.
Waiting for payments can be challenging, especially if your business is growing quickly and you have inventories sitting in your warehouse. Get in touch with the BlueX team about our A/R factoring solutions and how we can provide your business with immediate working capital.