Accounts Receivable Factoring: How It Works and Why Business Owners Should Know About It

Accounts Receivable Factoring: How It Works and Why Business Owners Should Know About It

Accounts Receivable Factoring: How It Works and Why Business Owners Should Know About It

This article was reviewed and updated on June 22, 2020

Ted Turner, founder of TBS, TNN, CNN, and Cartoon Network, says that, “Life is a game, and money is how we keep score.”

For the nearly 30 million small businesses in the United States—money is certainly a very important metric for determining how successfully a business is operating. The numbers don’t lie, as the income statement of a business shows if it is bringing in revenue, managing expenses properly, and if it’s generating enough profits to justify continuing—or needs to pivot in favor of something else.

For many of those nearly 30 million businesses, the fundamentals of their business model might in fact be strong in terms of creating revenue, competently managing expenses, and being able to generate a good profit margin, but poor cash flow can pull an otherwise healthy business down. That’s why effectively managing your accounts receivable (AR) is important.

If you offer payment terms to your customers, there is a way to access the value of your AR now, rather than waiting for them to pay over the next 30 or 60 days. Accounts receivable financing, also known as receivables factoring, could be a good way to access capital today to fuel growth or fund other business initiatives without borrowing.

How Factoring Accounts Receivable Could be the Answer

Using accounts receivable factoring could be important for your business if you are in fact operating within an industry where customers are granted payment terms to pay for goods or services. In some manufacturing industries and the textile industry, factoring is one of the financing vehicles of choice.

Accounts receivable factoring can not only protect the cash flow of a business, allowing a business owner to continue managing cash outflows—paying payroll, vendors, suppliers, property costs, etc., it also allows a business to leverage the AR for working capital rather than a small business loan or other cash flow loan. Accounts receivables factoring isn’t really borrowing, but is rather selling your accounts receivables at a discount. If your business offers payment terms to your customers, factoring could be a solution to cash flow challenges.

Keep in mind that invoice factoring can be expensive, and there are other options, including business credit cards, that could offer lower rates depending on your business credit score profile.

400 Years of Factoring

Factoring has been around for a long time. The concept of “receivable factoring” has been going on in the United States since the 1600s, when various colonists sought individuals to advance payments on raw materials that were being shipped to England.

Just about any business that offers payment terms to their clients could benefit from factoring. This includes the more well-known clients of factoring companies, including companies in industries such as:

  1. Manufacturing
  2. Trucking/Logistics
  3. Staffing
  4. Janitorial
  5. Security
  6. IT
  7. Printing
  8. Contractors, especially those who sell to the government

Other types of industries within the broad categories of retail and wholesale could benefit from the use of receivable factoring if they run into a cash flow crunch. However, the typical businesses that receivable factoring is best for are those that classify themselves as B2B (business-to-business) and B2G (business-to-government).

It All Begins With the Net D

The practice of offering customers payment terms is sometimes known as “Net D,” another name for “trade credit,” which represents how much of an outstanding invoice is required to be paid in full within a particular number of days.

As we exit the small business financial crisis caused by the corona virus, many lenders are either tightening their credit requirements or pulling out of lending altogether—at least in the short term. In a post-COVID world, factoring is one of the financing options that will still be available to small business owners before a bank loan, a line of credit, business credit cards, or other bank financing comes online.

Trade credit is one of the largest sources of financing utilized in the United States in general, and perhaps the biggest source of financing utilized by businesses. And in many industries, factoring receivables is a preferred way to access capital.

How Accounts Receivable Factoring Works

With accounts receivable factoring, you will work with a third party, known as a factor, or factoring company. The factoring company buys your invoices/receivables at a discount and will advance anywhere from 60% to 80%  back to you right now. The remaining 20% to 40% is paid after your client completes payment in full, minus a discount fee that usually ranges from 1% to 7%, depending on the credit and risk profile of your clients. (the factor is more interested in the creditworthiness of your clients than you, so even if you have a less-than-perfect credit profile, a factor may still work with you.) Factors also tend to work with specific industries where they know and understand the basic credit practices of the players.

There are two types of factoring agreements, recourse factoring and non-recourse factoring.

  • Recourse factoring is an agreement where you will remain liable for the value of the invoices should your customer not pay the factor.
  • Non-recourse factoring is where the factor assumes all liability for the value of the invoice should your customer not make payment.

Because of the greater level of liability, non-recourse factoring includes higher costs to you than does recourse factoring.

What’s Next

Factoring receivables does add additional cost to the goods or services you’re selling, so if you intend to enter into a factoring agreement, you’ll likely want to fold those costs into the prices you charge your customers. You’ll also want to make sure if you’re not doing business in an industry accustomed to working with factors, that your customers won’t be put off paying their invoices to a factor, rather than your business (however there are some modern accounts receivable factoring companies that will allow you to continue to accept payment from your customers, but that is the exception rather than the rule).

However, there are other methods to handle accounts receivables, which include a form of asset-based lending called accounts receivable financing, as well as a very similar method known as purchase order financing. Credit cards and lines of credit are another way to deal with bridging the purchase-payment gap. In the next discussion, I will touch on these options, and how your business could utilize these tools to avoid a cash flow crunch.

This article was originally written on June 13, 2016 and updated on January 29, 2021.

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