What is Accounts Receivable Factoring?

Mike, a small commercial painting/drywall contractor, found himself in a tight spot. Despite completing projects on time and maintaining a good reputation with his clients, he struggled to make payroll due to the extended client payment terms. When researching his options he had heard about accounts receivable factoring but was unclear what it was and how it could help his business through his cash flow gaps. If you are also wanting to learn about this financing solution and its benefits, this article is for you.

Contents:
– What is Accounts Receivable Factoring?
– Businesses that Benefit from AR Factoring
– Is Accounts Receivable Factoring a Loan?
– AR Factoring Fees
– What are AF Factoring Companies and What Makes Them Different?
– Accounts Receivable Financing Pros and Cons
– Is Factoring Receivables a Good Idea?
– What is Accounts Receivable Financing?
– Which is Right for Your Business?

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What is Accounts Receivable Factoring? How Does It Work?

So that we are all clear from the start, let’s start with the definition. Accounts receivable factoring is a financial option that involves the selling of outstanding invoices to a factoring company. They will advance a percentage of the invoice amount, typically from 70% to 90%, in as soon as 24 hours after the approval of the agreement. After receiving the invoice payment from your client, the factoring company will return the remaining 10% to 30%, less their fees.

What Businesses Can Benefit Most Using Accounts Receivable Factoring 

Accounts receivable factoring can be beneficial for businesses that face cash flow challenges when waiting for clients to pay their invoices. This is often the case in service-based industries like trucking, staffing, or construction. This solution is particularly beneficial for construction businesses especially smaller contractors and subcontractors in trades like electrical, plumbing, roofing, and concrete, who prioritize speed and flexibility in funding options.

Is Accounts Receivable Factoring a Loan?

Because the factoring company purchases your outstanding invoices and doesn’t loan against them, Accounts Receivable factoring is not a loan.

The AR Factoring Fees

Typical AR Factoring rates are highly dependent on many factors, the company or your industry for example, but generally, they run 1% to 5% of the invoice amount. Other determinants of percentage rates are often tied to how much time you need before repaying, your credit history, and the invoice amounts needing to be funded.

While these fees vary, all will be clearly spelled out in the factoring agreement.

>> READ MORE: Factoring Fees and Charges

What is Accounts Receivable Factoring With and Without Recourse?

Recourse and non-recourse refers to who will ultimately be paying in the event of a default. With recourse factoring, the business selling their invoice will ultimately be responsible for repayment if their client is unable to pay. Non-recourse factoring’s repayment does not fall back on the invoice-selling company. It makes sense that when the factoring company solely holds the risk with non-recourse, there will be higher fees to offset the potential risk.

What Makes Accounts Receivable Factoring Companies Different?

Because AR Factoring is a unique financial product, you will be working with a unique financial company. They are not typically banks, though it is not unheard of. Banks are typically highly risk-averse so they don’t like to offer financing to businesses they deem “risky” like construction, trucking, or staffing. This is where Accounts Receivable factoring companies take up the slack. Not only do they work with these industries, they might even focus on specific trades offering industry-specific benefits. Working with a factoring company that understands typical payment schedules, lien compliance, and other risk management, for example, can mean a much smoother, realistic working relationship. The last thing you want is to have added stress working with a company that just doesn’t understand the issues you are dealing with.

Pros and Cons of Accounts Receivable Factoring vs Bank Loans

PROS

1. much faster application/approval time
2. keep your extended payment terms with clients
3. it is easier to qualify for than bank loans with stringent requirements
4. because it is a purchase not a loan, the invoice acts as the collateral
5. smaller businesses with limited or spotty credit are welcomed
6. offer additional industry-related services

CONS

1. higher interest rates or fees than bank loans
2. the factoring company will communicate directly with your client about payment
3. if your client does not pay the invoice, you might be liable

>> RELATED READING: The Pros and Cons of Factoring — Extensive List

Is Factoring Receivables a Good Idea?

After you understand all the pros and cons, you will see that factoring can be a viable option in certain situations. Over the past 25+ years, we have worked with construction businesses that have been a perfect fit — quickly getting the paperwork completed, easy-to-work-with clients, and they quickly received their money. But have also worked with businesses that let’s just say, were more difficult – messy documentation, non-responsive clients… you get the idea. The business in the first example, factoring was clearly a great solution for everyone involved. However, for the second business, their limited ability to get other forms of financing made factoring the best of their limited choices.

It’s essential to understand that this financing solution isn’t only for businesses experiencing financial shortfalls. We have worked with construction businesses that have proactively used factoring as a strategic option. They created their account knowing that they could submit invoices for “quick, easy money” in the event there were any issues with cash flow during times of future, anticipated growth, similar to a line of credit.

Accounts Receivable “Financing“? What’s that?

Although the names are similar, Accounts Receivable Financing is actually closer to a traditional loan. This form of financing allows a business to borrow money using the value of an outstanding invoice(s) as collateral. After the client pays the invoice, you pay the AR Financing company back.

Keep in mind that you might hear the term Accounts Receivable Financing used in two different ways. There is the Accounts Receivable Financing discussed above, but you might also hear: “accounts receivable financing” — a generic usage for any form of financing that involves accounts receivables or invoices.

So, is AR Factoring best for your business?

If you believe AR Factoring is the right option for your business, you will need to know how to compare factoring companies. The easiest would be to check out our guide entitled: How to Pick the Best Factoring Company.

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