Accounts receivable factoring, also known as invoice factoring or business receivable factoring, is a method of business financing that companies sometimes use to help manage cash flow and meet expenses. Factoring receivables involves a different process than taking out a bank loan, but the general goal for both is often the same: to provide the business with needed cash.
For clarity, a factoring company or factor is a lender that provides financing through the invoice factoring process. In other words, the lender gives the small business financing in exchange for unpaid invoices.
Learn more on what accounts receivable factoring is, pros and cons of this type of financing, and alternatives you may want to consider.
What Is Accounts Receivable Factoring?
Factoring accounts receivable is a method of financing that B2B companies that invoice their customers and vendors could consider when they’re in need of quick cash. Basically, the business gets a loan from a factoring company using its accounts receivables as security.
Typically, the factoring company will give the business a percentage of its outstanding invoices (the advance percentage, which is typically around 80%). When the invoices are paid by the customers, the factoring company gives the remaining 20% to the business, minus any factoring fees (which can be high).
Recommended: What Are Accounts Payable?
How Does Factoring Accounts Receivable Work?
Here’s a basic illustration to show how accounts receivable factoring works.
Let’s say that your business has issued $20,000 in invoices that haven’t been paid yet. Let’s also say that your business will be $10,000 short in meeting payroll if those payments aren’t made on time.
To address the situation, your business might decide to factor receivables in order to get enough cash in to pay your employees. This would involve selling the unpaid invoices to a third-party factoring company (or “factor”).
At this point, the factor would own the invoices and your business would receive a certain percentage of the dollar amount on them. This is called the “advance rate.” The advance rate that your business would receive would be based on how risky the transaction is for the factoring company.
The difference between the dollar amount on the invoice and the amount your business gets upfront is held in reserve until the invoices are paid. Once your customers have paid, the remainder is forwarded to your business, minus the factoring fee.
Factoring Accounts Receivable Example
To give some numbers to the example, let’s say that your business qualifies for an advance rate of 80%. To meet payroll expenses of $10,000, you decide to factor $15,000 out of your $20,000 in outstanding receivables.
The factoring company would then issue you 80% of the value of the receivables being factored ($15,000 x 80%): $12,000. You could then use $10,000 of the funds to pay your employees and have $2,000 left over for miscellaneous expenses.
The next step is for your customers to pay their invoices in full (that money goes to the factor, not directly to your business). Once paid, the factoring company will release the reserve amount (in our example, 20% of the invoice amount, or $3,000) minus the factoring fee charged by that particular factor.
How Are Factor Fees Calculated?
A factor may consider a number of things to determine what factor fee to charge your business. It might look at the industry your business is in, how many invoices are involved, your customers’ payment histories, and your company’s financials to determine what factor fee to charge you.
That said, typically these fees run from 1% to 3% of your invoices, but may go as high as 5%.
Bear in mind that you might have to pay a flat factor fee for each week that an invoice goes unpaid — 2% the first week, 2% the second week, and so on. But some factors charge a tiered factoring fee, meaning that the amount of your fee can go up if the invoice isn’t paid right away. So while the factor fee might be 2% the first week, it might rise to 3% the next week.
Recommended: Business Cash Management: Tips for Managing Cash
How to Qualify for Accounts Receivable Factoring
Qualifications for accounts receivable financing are much less stringent than for other types of small business financing, such as small business loans or business lines of credit.
With accounts receivable financing, the invoices serve as collateral, making it an attractive form of borrowing for businesses without strong credit histories. To qualify, you simply need to have outstanding invoices from reliable customers. The factoring company will look at the credit history of your customers as opposed to your business.
Recommended: Business Loans Based on Revenue
Pros and Cons of Accounts Receivable Factoring
Even companies that focus on cash management strategies sometimes need an influx of cash — and, for some of them, invoice factoring can be a good solution. Just as with other forms of small business financing, though, there are pros and cons to accounts receivable factoring.
Advantages of Accounts Receivable Factoring
Benefits may include the following:
• No collateral is required, other than the invoices.
• You can typically access the cash quickly.
• Factoring can help your business manage cash flow.
• Lenders typically focus less on the business’s or owner’s credit score and more on the creditworthiness of the customers owing on the invoices.
• Some factors will work with startups.
• Funds provided by a factor can typically be spent in any way the business desires, with no restrictions.
• The factor company takes over collecting on the invoices, freeing up your business to handle other tasks.
Disadvantages of Accounts Receivable Factoring
Cons of accounts receivable factoring can include the following:
• Rates can be relatively high. Plus, there can be a variety of fees, including application, processing, and service fees, which means that factoring can be a more expensive way of getting business funding. This can be especially true if the invoiced customers don’t pay on time.
• The factoring company has control of the invoices after your business sells them. That’s why it’s important to choose a factor that will treat your customers fairly and with respect.
• If customers don’t pay the invoices that were factored, your business may need to pay for those invoices, along with added fees.
• If a business’s customers aren’t creditworthy, then it may be difficult to factor accounts receivable from them.
• What a factor charges will depend on the creditworthiness of the invoiced customers, how old the invoices being factored are, the invoice due dates, and more. Just as with banks that make loans, it’s important to compare what different factoring companies would charge.
Recommended: Types of Small Business Loan Fees
Accounts Receivable Factoring vs Accounts Receivable Financing
Accounts receivable factoring gives the lender full control of the unpaid invoices. Your business no longer owns them; instead, the factoring company does. With accounts receivable financing, on the other hand, your business still owns the unpaid invoices.
To qualify for accounts receivable financing, or invoice financing, your credit score and financial history are taken into consideration. With accounts receivable factoring, it’s the credit history of your customers that’s taken into account.
Recourse Versus Non-Recourse
These are two different factoring models: recourse and non-recourse.
When a factor uses a recourse approach, this means that a company would be responsible for any factored invoices that its customers didn’t pay.
When factors are using a non-recourse approach, the factoring company is responsible for any unpaid invoices. There can be exceptions to this rule if certain conditions are met, though. For example, if an invoiced customer files for bankruptcy within a defined window of time or goes out of business, the business might not be held responsible for its invoices. Non-recourse factoring companies may charge a higher fee because they’re taking on more risk.
Recommended: What Is Traditional Income Statements Explained
Choosing the Right Factoring Company
Just as with any lender, you should check out factoring companies that you might want to work with carefully to make sure they’re trustworthy.
• Is it registered in your state?
• Does it have good reviews online?
• What is its Better Business Bureau ranking?
• Does it specialize in specific industries? (Some factoring companies work with very specific industries, such as medical or freight transport, while others are more general.)
• What are its rates and advance percentages?
• Is there a minimum number of factoring transactions required each month?
• If there are no minimum requirements, will factoring a certain amount of invoices each month provide your company with a discount?
Once you settle on a factoring company, the factor will then conduct due diligence on your business and on the customers whose invoices may be factored.
After that review is satisfactorily completed, the factoring company will offer an agreement that should be carefully reviewed. Check the interest rate and fees, including whether there is a cancellation fee. See if any minimum factoring amounts are listed, whether there’s a contract term that you’re agreeing to, and so forth.
Alternatives to Accounts Receivable Factoring
While accounts receivable factoring is one way to get cash for your business, there are other ways, too.
Free Up Cash Flow: Ways to free up cash flow include cutting expenses, increasing pricing, and turning invoices into cash more quickly, perhaps by offering early pay discounts to customers and/or asking for a deposit when orders are made.
Business Line of Credit: Getting a business line of credit from a bank or online lender gives you access to a certain amount of funding decided upon by the lender that you can draw on at will. Interest is charged only on unpaid balances. Business lines of credit are typically revolving credit that replenish how much you can draw as you pay back whatever you owe.
Online Business Loan: Online lenders frequently provide loan options similar to those of a traditional bank. However, typically online lenders have a faster approval process. What’s more, they may offer more options for business owners with lower credit scores.
The Takeaway
Accounts receivable factoring is a method of small business financing where you sell your invoices to a factoring company. You receive a percentage of the invoices upfront, and the remaining amount (minus any fees) when the invoice is paid in full. However, depending on your situation, accounts receivable factoring may not be the best type of financing for your small business. Other options include traditional small business loans, small business lines of credit, and SBA loans.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
What is accounts receivable factoring?
Accounts receivable factoring is a type of small business financing where you sell your unpaid invoices to a factoring company. You receive a percentage of the invoices immediately, and once the customer pays the invoice, you receive the rest, minus any fees (which can be expensive).
How do you calculate AR factoring?
Accounts receivable factoring is calculated by first determining eligible invoices. Ideal invoices are no more than 90 days late and are owned by creditworthy customers. Then, the factoring company will determine how much of the invoice they’ll give you — typically 80-90% of the invoice total. Once the customer pays the invoice, the factoring company will give you the remaining percentage, minus any fees.
Photo credit: iStock/Thapana Onphalai
SoFi's marketplace is owned and operated by SoFi Lending Corp. See SoFi Lending Corp. licensing information below. Advertising Disclosures: SoFi receives compensation in the event you obtain a loan through SoFi’s marketplace. This affects whether a product or service is featured on this site and could affect the order of presentation. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
SOSB0424034