Question – How Does Accounts Receivable Financing/Factoring Work?
Our Response – There are some instances where a loan may not be the best option such as when a business gets a large order but doesn’t have the cash to purchase the inventory or wait for payment. If this is the case, accounts receivable financing or factoring may be a better solution.
Factoring is the selling of a company’s accounts receivable, at a discount, to a factoring agency, which then assumes the credit risk of the account debtors and receives payment as the debtors settle their accounts. Factoring can provide a quick turnaround and convenient funding to growing companies who need capital to expand their business. Factoring is not a loan. There is no debt repayment, and long-term agreements are not necessary. For their services, Factoring agents are paid a fee, which is typically based on a percentage of to accounts receivable. Accounts receivable financing on the other hand is a loan secured by a company’s accounts receivable. A financing company would provide a line of credit, using the accounts receivable as collateral.
Although factoring and accounts receivable financing are often discussed as if they are the same, there are some differences between these financing vehicles.
Factors purchase accounts receivable at a discount and charge fees. Typically, the factor will advance the company 70-90% of the face value of the invoice. When the factor receives payment from the third party, it releases the balance, minus fees. The fees are based on the time taken to collect, the size of the receivable, and the credit history of the business’s customer. Typically, fees range from 1.5 to 5.5% of the total value of the receivable. The cost is a huge drawback to factoring but the advantage of going with factoring is that funds can be available within 24 hours. By factoring your business is also in most cases getting away from payment risk as the factoring company is essentially taking it on. With accounts receivable financing, the businesses still retains the risk that their customer won’t pay, which in addition to slightly slower funds availability, the cost of financing is usually less expensive.