First, let’s make sure we’re on the same page. Some people use the terms “accounts receivable financing” and “factoring” interchangeably and will tell you they are one and the same. Others will insist vehemently that they are not.
Accounts receivable financing and factoring are not, in fact, the same thing, though they have enough elements in common to cause this confusion. If you are reading this article because you hope to learn about factoring, never fear, we’ll deal with both.
What is Accounts Receivable Financing?
Accounts receivable financing is a financing arrangement that allows a company to borrow against its receivables—money that is owed to the company by customers that have not yet paid for their purchases.
It’s a common way for many companies, especially those that make large sales and must wait 30, 60, 90 days or more for customers to pay their bills, to obtain the cash they need.
The company’s accounts receivables serve as collateral to secure a loan from a finance company or bank, much the same way that a traditional bank loan might be secured by real estate or an investment portfolio.
More accurately, a certain percentage of the market value of qualified receivables (typically 70-90% of invoices less than 90 days old) establishes a “borrowing base” against which the company may borrow. The process is similar to setting up a line of credit. The borrowing base is reviewed and revised periodically as new invoices are issued and old ones are paid.
The finance company makes its money by charging interest on the outstanding loan amount and assessing a collateral management fee that’s generally in the range of 1-2% of the outstanding amount. The lender also may charge a due diligence fee to cover the cost of reviewing and verifying the company’s invoices.
How Does Factoring Differ from Accounts Receivable Financing?
The primary difference is that a finance company, known as a “factor,” buys a company’s accounts receivables rather than using them as collateral for a loan. The factor advances the company 70-90% of the value of each qualified invoice.
The customer’s payment goes to the factor instead of directly to the company. When the factor receives a customer’s payment, it deducts a percentage (usually somewhere between 1.5 and 5.5%) of that payment as its factoring fee and releases the balance to the company.
Why the Confusion?
There’s no doubt that many people conflate accounts receivable financing and factoring, and the confusion is probably due largely to the terminology used. Both accounts receivable financing and factoring are types of asset-based financing, and the companies that serve as factors are formally referred to as accounts receivable financing companies.
By the time you reach the end of this article, you should have a good handle on whether it’s accounts receivable financing or factoring you’re really interested in.
What Companies Use Accounts Receivable Financing or Factoring?
Some companies use such asset-backed financing arrangements because they need an immediate solution for a short-term cash crunch. Others use accounts receivable financing or factoring to carry them through a transitional period until their finances have improved enough to meet the credit requirements for a traditional bank loan or other type of financing.
There are some industries that have long relied on accounts receivable financing or factoring to meet their cash flow needs. The garment industry is a good example. It can be months between the time that garment manufacturers purchase fabric and pay for until the retailers and other businesses they sell to pay the invoices for their purchases.
Being able to borrow against or sell their outstanding invoices is essential to their ability to continue doing business. Trucking is another good example of an industry that relies on such asset-based financing. And businesses in the health care industry are increasingly turning to accounts receivable financing.
There are any number of reasons why a company might consider accounts receivable financing or factoring, such as:
- Maintaining sufficient inventory of materials and supplies to support ongoing manufacturing operations
- Very long sales cycles
- Unpredictable cash flow
- Seasonal sales volatility
- Customers that are slow to pay, such as government agencies or large corporate buyers
- Unexpected surge in customer demand
- Purchase of new equipment or technology
- New market opportunities
- Need to expand capacity
- High or increasing production costs
Which is the Better Choice?
Whether accounts receivable financing or factoring or any type of asset-backed financing at all is appropriate for a particular company is a choice that requires careful consideration and comparison of the options. The chart below should help you make the right decision for your business.
|Accounts Receivable Financing||Factoring|
|Flexibility||Less flexible; all qualified invoices are submitted as collateral||More flexible; company can choose which invoices to sell
|Credit Requirements||Must meet higher credit standards||Easier for smaller and financially challenged companies to qualify
|Fee Structure||More complicated fee structure applied to entire base||Simpler fee structure, applied on an invoice-by-invoice basis
|Cost||Usually less expensive because lender has collateral, so risk is lower||Generally more expensive because risk to factor is greater and factor purchases invoices at a discount
|Approval Criteria||Very small companies may not qualify; typically required to have at least $75,000 in monthly sales||Factors generally will work with small companies and start-ups (less than $30,000 in monthly sales)
|Minimum/Maximum||Borrowing base is typically $700,000 and up; can go up to several million||No minimum amount required
|Impact on Finances||Loan has an impact on the company’s current debt situation||No impact on debt utilization or debt-to-equity ratio
|Interest||Interest charge on loan is usually higher than for a traditional business loan from a bank; APR is typically 7-5%||No interest charges
|Amount Company Receives||Loan amount is 75-85% of value of invoices held as collateral||Factor advances 75-95% on invoices; when invoice is paid, fee is deducted, the balance is returned to the company so that company typically receives 97-99% in total
|Invoice Collection||Company keeps ownership of receivables and must collect on its own invoices||Factor owns invoices and must collect payments from customers
|Credit Protection||Company takes the hit if customers don’t pay||Factor takes the hit because they now own the invoices
|Repayment||Company must meet lender’s repayment schedule||No repayment because there is no loan involved
|Customer Contact||Customers are typically unaware the company is using accounts receivable financing||Customers are contacted by factor to verify invoices, so they know the company is using factoring
Advantages Over Traditional Bank Loans
Companies that ultimately enter into an accounts receivable financing or factoring arrangement usually do so because they can’t get approved for a traditional bank loan. Over time, such companies often become more “bankable” and can transition to traditional bank financing.
But that’s not to say that asset-based financing methods don’t have any advantages over bank financing. For one thing, the amount of cash companies gain access to through accounts receivable financing or factoring is generally much more than a bank would lend them.
Another advantage is that they can often receive that cash more quickly than a bank loan would be funded. This can be a significant advantage for companies seeking quick cash to take advantage of a short-term opportunity.
A serendipitous benefit for some small companies that enter into a factoring arrangement is that it cuts down on the time and labor required to chase after customers for payment, because the factor takes on that responsibility. It can even eliminate altogether the need for an accounts receivable department.
Another alternative to accounts receivable financing and factoring is to raise capital from private equity investors. However, that dilutes ownership, which is not an issue with asset-based financing.
Accounts receivable financing and factoring are dynamic relationships that can evolve as a company grows. The amount of cash available to the company increases along with its sales, without having to go back to a bank and request another loan.
The lender or factor may also be willing to negotiate terms and fees over time, and a very large volume of business can result in very attractive interest rates. For some companies, especially in industries where accounts receivable financing and factoring are common, there is no need or desire to transition to traditional bank financing.
What to Look for in an Accounts Receivable Lender or Factor
The quality of a company’s experience with asset-based financing is greatly influenced by its choice of lender or factoring firm. There are a few important considerations, such as fees and charges, service quality, communication, and location.
Be aware that being informed by a finance company that future invoice payments should be made to the factor, can cause customers to lose confidence in the seller they have been doing business with. It’s important to choose a factor that will explain that change properly so as not to damage the customer relationship.
Give careful thought to whether accounts receivable financing or factoring is the way to go to meet your company’s cash flow needs, then shop around to find the best bank, financing company, or factor to help you.
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