Factoring Receivables: Guide on Everything You Need To Know

If your small business has unpaid invoices affecting cash flow, factoring receivables can be a good financial solution. In short, business owners work with a company that collects customer or client payments on their behalf, freeing up valuable time and bringing in much needed revenue.

Here’s a guide to help you determine if this funding option is right for your unique business.

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What businesses are good candidates to factor receivables?

Some businesses, particularly those that bill customers or clients, may be able to rely on unpaid invoices to secure funds. (Of course, this strategy is not an option if your business doesn’t rely on invoices for payments). Businesses who benefit from receivables factoring may have the following characteristics:

  • Insufficient credit history or bad credit scores
  • Troubled past including prior bankruptcies or forbearances
  • Credit denied or maxed out
  • Small businesses with rapid growth
  • Operating losses
  • Negative net worth
  • Highly leveraged
  • Delinquent taxes
  • Lack of collateral

The above situations can keep a company from getting a low-cost business loan or other funding so factoring is a good option.

How factoring invoices works

When factoring receivables, the business will receive an advance that’s typically 80% of the invoice amount at the point of purchase. Once the invoice is collected, the business owner gets the remaining 20% less a fee.

The concept of using accounts receivable factoring is fairly simple and generally involves the following seven steps. Factoring companies streamline the process to provide an easy experience compared to chasing down payments yourself.

  • Your business issues invoices for good or services due in 30 to 90 days
  • You set up an account with a factor.
  • You submit your outstanding invoices to the factor.
  • The factor provides an immediate cash advance based on an agreed percentage.
  • The debtor pays the invoice.
  • The payment is deposited into a temporary reserve account.
  • The factor deducts the fees and amount advanced and wires the balance to your bank account.

Working with a factoring company can be a win/win. You’ll avoid the hassle, stress, and time required to collect late invoices and the factoring company gets paid for their funding and collection services. Note that some factoring companies have “non-recourse factoring” in their contracts. This means that they assume the risk of non-payment. Others reserve the right to “recourse” on bad debt. This means that if the invoiced client does not pay, they will ask you to repurchase the invoice. This is an important detail so be sure to check the contract closely and ask if you have any questions about fine print.

Example of accounts receivable factoring

Here’s how factoring can work to get you the cash your business needs to run effectively.

If you have a $10,000 invoice, due in 30 days and need to purchase inventory to jump on a new opportunity, you can factor the invoice for immediate cash.

The factoring company has a discount rate of 2% per month. Their terms state that you will get 90% of the invoice cost immediately and the remaining amount of the invoice when once your client makes full payment.

You’ll receive a $9,000 advance so you can purchase the inventory to keep your business expanding. When your customer pays in 30 days, you will get $800 back which is the remaining invoice amount ($1,000) minus the 2% discount rate ($200).

In this example, the total factoring cost is $200.

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When to consider accounts receivable factoring

Here are reasons accounts receivable factoring can work for your small business:

When You Don’t Qualify For A Bank Loan

Banks look at your business performance and credit rating, among other financial details. However, factoring companies allows businesses to leverage the strength or the creditworthiness of their clients when they apply for financing. If a business has a low credit score, insufficient bank history, or negative bank balances, they still may be able to receive factoring financing.

When You Need More Than One Source Of Capital

You might already have a bank loan or other financing in place. But factoring can get you extra funding you need if an immediate opportunity comes up quickly. Factoring can also get you through slow seasonal times when your loan or other financing is not enough.

Accounts receivable factoring common uses

Here are ways a business owner can use funds from factoring receivables as a financial fix.

  • Solving short-term everyday working capital crunches due to uneven cash flow
  • Employee salary, benefits, and commissions
  • Business travel
  • Marketing
  • Providing cash liquidity without taking on debt
  • Fueling business growth when new opportunities arise
  • Maintaining inventory or materials for on-going or new projects

Benefits of accounts receivable factoring

There are a lot of pros for a business owner considering factoring as a source of capital. They include:

  • Fast cash flow boost
  • You can give terms to your customers without worries
  • Low qualification requirements and simple application process
  • High approval ratio
  • Cash flow without debt
  • No collateral or personal guarantees required – invoices serve as collateral
  • Minimal credit score requirements
  • Operational support to A/R department
  • Much cheaper than invoice financing

Disadvantages of factoring receivables

Before you jump on board with factoring, look over these cons to see if you can take the risks and drawbacks.

  • Not accessible to B2C (those that work only with consumers)
  • More expensive than traditional business financing
  • Not a solution for unpaid invoices that are late or delinquent
  • Liability for non-creditworthy customers (in most cases)
  • You give up a portion of profits when factoring company takes their cut
  • Finance companies contact your customers or clients, giving you a loss of some communication control

How much does it cost to finance receivables?

If you don’t have a clear picture of your financial landscape, don’t jump into factoring. Make sure you can afford the fees and loss of the complete invoice amount.

Generally, accounts receivable financing costs a business approximately 1% to 5% of the actual amount borrowed. However, it can depend on the industry you're in. The collateral management fee can vary as can the total amount of money provided up front.

If you’re not sure this is the right step, check with your bookkeeper, accountant, or other financial professional. They may be able to suggest better alternatives.

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