The Basics of Accounts Receivable / Invoice Factoring

The principle behind factoring has been around for just about as long as people have been doing business with one another at a level more complex than the barter system. In the online age, invoice factoring makes it easier for small businesses to get some quick liquidity in order to meet operating and other types of needs.

How Does Invoice Factoring Work?

When you have accounts receivable and take an advance against them, that is what “factoring” represents. The actual “factor” is a third entity that purchases your business’ receivables for a discounted rate. Then the factor collects directly from your customers and makes a profit from the difference between the discounted rate and the full collected amount.

The majority of factoring companies use a two-installment process to complete the purchase. The initial installment (the advance) can cover between 40 and 80 percent of the amount of the receivable, depending on the arrangement. The rest of the receivable, minus the factoring discount and any fees, comes to you as soon as your client makes payment in full.

Quite a few companies make their money in independent factoring, operating either in brick-and-mortar fashion, online, or both, and there are also many banks that provide this service. The majority of factors go after certain businesses because they know that those businesses generate a lot of volume. There are some factors who work within specific industries, such as the textile business.

As part of starting a relationship with a factor, they are likely to go through your list of clients to see how creditworthy they are. They’ll also look at your last invoices and see how easy it has been for you to collect balances due. If everything matches the factor’s specifications, then they will negotiate with you to put together a factor rate. There aren’t really any industry standards, but in general you should expect that the factor will make you an offer somewhere between 85 and 90 percent of the invoice face amounts and advance some percentage of that total up front. The exact numbers will depend on the creditworthiness of your clients and your past collection record.

Factors will also expect to collect a fee that ranges between 2 and 4.5% of the invoice amount for every month that the invoice remains unpaid after factoring. Once your agreement is executed, you can expect the advance payment within one to three business days. After the factor collects the total invoice value from your client, you’ll get the rest of your discounted amount, with any fees taken out. Fees vary depending on the creditworthiness of your customers and the dollar amount of the invoices.

If you’re new to factoring, you need to know that the factor will collect the invoices directly and is authorized legally to communicate directly with those clients.

Recourse factoring means that, if the factor cannot collect on some of your receivables within an agreed amount of time, you will reimburse the factor for those uncollected invoices. Non-recourse factoring puts all the risk for uncollected invoices on the factor. As you might expect, fees are higher in a non-recourse agreement in most cases.

Does your company take in a significant amount of income from invoices that clients pay over time? If so, and if your company could use the liquidity from those invoices now, you can take advantage of factoring to get the money now (at a discount). Factoring companies profit by purchasing account receivables from companies like yours, giving you cash up front that you can use to pay for needed business expenditures.

Does your small business have several clients, each of which does a lot of business over time with you? An example might be a deli that caters lunches for several large businesses in town. If the deli’s customers are primarily individuals who come in for sandwiches, then factoring might not work as well. It’s more common in manufacturing because the cycle of generating consumer goods and distributing them through channels to the customer can take a longer time, which makes receivables more of a reality. Industries that focus on B2B sales also have more of a use for factoring.

If so, factoring can be a good route to cash without debt. The rate that you give away in terms of discounting can make it more expensive than a line of credit, though, and your clients may not like dealing with your factors directly.

As with any business arrangement, you need to consider whether it’s the right fit for you, and if your business will get what it needs in terms of liquidity out of factoring given the percentage of your invoices that you will give up in discounting and fees. Also, you’ll want to review all of the paperwork carefully before entering the agreement.

The Invoice Factoring Process

To get things started, you need to find a factoring company. Quite a few factoring providers have experience in various industries, and many of them focus on a particular industry. The best place to start is with a company that has factoring experience in your industry.

Once you’ve found a company that works in your industry, the next process is to set up an account. Make sure that you review all of the terms of the contract before signing. Afterward, the factoring company will look through the receivables you’ve submitted, check out the creditworthiness of your clients and publish notices of the assignment of your company’s invoices.

After setting up your account, you’ll submit a schedule of accounts, which is a list of the invoices you’re wanting to sell to the factor company. The company takes your invoices, verifies them with your clients, and then sends you the advance. This advance can come through an ACH payment, which can take a couple of business days (depending on your bank), or it can come through a wire transfer, if you need the money right away.

After the client pays your invoice in full, then you receive the rebate, which is the second installment. If your advance was 60 percent of the total of the invoices, then the rebate will be the remaining 40 percent, less the factoring discount and any fees. Depending on the factoring company, the rebate may come as soon as your client pays your invoice in full, or distribution can take place on a weekly, bi-weekly or monthly basis, in batches.

Most companies that engage in factoring do so on an ongoing basis, so that their cash flow is predictable and regular. Invoice factoring can serve as a sound source of ongoing cash for your company.

Companies that have a significant number of invoices outstanding with business clients who are slow to pay have been using invoice factoring more frequently in order to gain the liquidity they need to meet their daily expenses. Invoice factoring involves companies receiving advances on their outstanding invoices with clients from third-party companies, in exchange for a discount on those invoice amounts as well as fees. As with any form of financing, there are advantages and disadvantages, which you’ll want to check out before taking out this sort of contract.

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Factoring Invoices: The Advantages and Disadvantages

There are some advantages to this approach – and some disadvantages. The qualification process does not take much time or involve much paperwork. These advantages can make factoring the right choice for companies that are on the rise or just getting up and running and need cash now – and have the outstanding invoices to make the process worthwhile.

The primary benefit that factoring can provide for your company is cash up front. This immediate liquidity should repair your cash flow problems and give you the resources that you need to take care of your short-term expenses and grow to expand your business.

If you’re still a growing business, you may not have the flexibility to offer 30-day or 60-day terms on your invoices. However, the majority of government and large private companies will want the flexibility to pay in those terms instead of on demand. You won’t land contracts with those organizations or companies if you cannot offer those terms. If you want to grow as a company at all, factoring may well be necessary for you to secure the business of these larger clients.

Invoice factoring is one of the easier business financing solutions to secure. Factoring companies are only interested in knowing if you have invoices that are due from customers who have adequate credit. As long as your own business has no legal problems or liens pending, and you have invoices for delivered jobs, then you should receive your factoring with no problems.

Are you wondering how creditworthy your clients are? Most contracts for factoring include reviews of client credit. Once you have a contract with a factoring company, they will run credit reviews of your potential clients, so you can decide whether to extend them 30-day and 60-day terms.

If your number of invoices increases, then the amount of factoring advance cash that you can receive up front can increase as well, if you choose to use them in this way. If you are going through aggressive growth and need liquidity to keep up, factoring can be a real boon to your company. If you only need the liquidity for a short period of time, you can stop sending in invoices as soon as your liquidity reaches where you need it to be.

Finally, you don’t have to put up any collateral other than your invoices. You’re not surrendering any equity, and you don’t have to have any capital assets as security, as you would with a loan or line of credit.

The cost of factoring is the largest disadvantage. You can expect to pay anywhere from 1 to 4 percent in discounts and fees for every 30 days an invoice remains outstanding. Annualized, that becomes much more expensive than some of the other financial solutions out there.

There’s also the fact that factor companies will contact your customers. That can lead to friction between you and your clients, particularly if the clients fall behind on their payments. Also, factoring companies are not collection agencies. So if your clients end up not paying the invoices that you send to factor companies, you can end up on the hook for paying your advance back.

Factoring and Accounts Receivable Factoring: What’s the Difference?

Businesses continue to find it difficult to access the credit they need for keeping operations running smoothly and for expanding their businesses, at least if they limit their applications to banks and other traditional lenders. However, many companies are finding access to liquidity using a variety of alternative financing options.

Two of the more commonly used methods are factoring and accounts receivable financing, or A/R financing. Many business owners use those terms interchangeably, but there are some key differences worth noting.

Factoring happens when a commercial finance company, also known as a “factor,” buys the outstanding accounts receivable that a business holds. The factor advances between 70 and 90 percent of the face value of the receivables upon purchase, and then pays the balance when the invoice is collected, less the fee for factoring. This fee can range anywhere between 1 and 5 ½ percent, depending on the length of time repayment takes and the relative risk associated with the client.

Most factoring contracts allow businesses to decide which invoices they want to sell to the factor, which means that there is no commitment to sell all of a company’s receivables. The factor manages each invoice until the client pays it, which basically means that the factor is responsible for managing the business’ credit decisions and communication with clients who owe on invoices.

Accounts receivable financing is somewhat different, closer to a traditional bank loan. In this situation, the business pledges assets that are connected to accounts receivable as collateral on a loan. A typical arrangement might set up a borrowing base of between 70 and 90 percent of the qualified receivables at a draw, and the business can decide how much to borrow at that point. The lender charges a collateral management fee (usually around 1 or 2 percent) against the outstanding total. Interest is only assessed when the business accesses the line of credit. To qualify for this sort of arrangement, an invoice usually has to be less than 90 days old, and the associated business must match the finance company’s creditworthiness standards.

So while the two types of factoring are similar, let’s review the key differences.

Factoring permits more flexibility than accounts receivable financing, because businesses get to select which invoices they will sell to the factor. Qualification is fairly simple, making it a quality idea for new companies and companies going through difficult times in terms of credit. The fee structure is also fairly cut and dried.

Accounts receivable financing usually costs less on an annual basis than factoring, and once a company gains the sort of credit to deal with a bank loan, it can be easier to transition from A/R factoring to a traditional loan. However, this arrangement is not as flexible, because a business has to submit all of its receivables as collateral. Finally, this generally requires at least $75,000 in monthly sales to qualify, so smaller businesses may not be able to do this.

Both of these funding vehicles are considered transitional financing options that can help a business stay afloat during a time period when it cannot quality for traditional financing through a bank. Many companies stop factoring after they become creditworthy, a process that can take a year or two. There are some industries, such as trucking and textiles, in which factoring basically happens indefinitely.

Whether it be invoice factoring, a business loan, or a merchant cash advance; Amansad Financial Services / Best Bridge Capital has the key relationships with the industries top funders to ensure you find the right product for your business… and quickly.