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?
Is Accounts Receivable Factoring a Loan?
What is an AF Factoring Company?
What is Accounts Receivable Financing?
AR Factoring vs. AR Financing
Is Factoring Receivables a Good Idea?
Which is Right for Your Business?


What is Accounts Receivable Factoring? How does it work?

First, let’s start with the definition. Accounts receivable factoring (or AR factoring for short) involves selling an outstanding invoice or invoices to a third-party company – an AR Factoring company.

After purchasing your invoice(s), the Factoring company will advance you a percentage of the invoice amount, typically from 70% to 90%. This advance can happen as little as 24 hours after the approval of the Factoring agreement. After receiving the final payment from your client, the Factoring company will return the remaining 10% to 30% to you, less their fees. These fees vary by industry and company but will be clearly spelled out in the Factoring agreement.

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

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.

What makes an Accounts Receivable Factoring company 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.

Accounts Receivable Factoring and Accounts Receivable Financing compared

AR Financing? What is it?

Accounts Receivable Financing is similar to a traditional loan that 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.

What is the difference between AR Factoring and AR Financing?

Both options have their merits depending on your company’s situation. If you have good credit and the time to be approved, AR Financing might be the way to go. However, if you need funds quickly and have a limited (or no) credit history, AF Factoring would be the better choice.

Pros & Cons of Accounts Receivable Factoring vs Accounts Receivable Financing

Pros and Cons of Accounts Receivable Factoring

PROS

  1. much faster application/approval time
  2. the client’s credit rating is used so it is usually easier to get
  3. keep your extended payment terms with clients
  4. offer additional industry-related services

CONS

  1. higher interest rates
  2. the factoring company might communicate directly with your client about payment

Pros and Cons of Accounts Receivable Financing

PROS

  1. lower interest rates than factoring
  2. you retain control of your invoices

CONS

  1. like with most loans, financing can be slow to receive
  2. you will need an established, favorable credit history
  3. the responsibility of collecting invoice payments remains with you

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.

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

So, which is best for your business?

Now that you understand the difference between both AR Financing and AR Factoring, one option should stand out as “the one”. If you believe 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.


Curt Powell VP of Sales

About the Author:
Curt Powell — VP of Sales
Joining the team in 2016, Curt serves as the Vice President of Sales at CapitalPlus Financial Services, a direct lender based in Knoxville, Tennessee focusing exclusively on the construction industry. During that time he has walked thousands of business owners through the financing options to find the best solution for their needs.

Curt is a member of The International Factoring Association, The Association of General Contractors, and the Construction Financial Management Association.

CapitalPlus was established in 1998 providing over $1 billion in factoring funds empowering thousands of construction companies all over the US.

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