What is accounts receivable factoring?
Accounts receivable factoring, also known as invoice factoring, is a way for businesses to secure financing by selling their unpaid invoices for cash. This allows them to increase their working capital in the short term, bypassing the need to wait for customers to settle their outstanding invoices.
It involves a third party (called the factor) who buys outstanding invoices and takes control of the collections process. The factor usually pays 70-90% of the invoice value up-front before paying the final remaining amount (minus a factoring fee) when they’ve received payment from the customer.
Accounts receivable factoring, therefore, offers two main potential benefits to companies. Firstly, it allows them to speed up their cash flow by receiving outstanding payments without having to wait out the established payment terms. Secondly, it means they don’t have to use their own resources to manage the invoice collection process, freeing up time to spend on other activities.
It’s one of several types of receivables finance available to businesses, alongside other options like accounts receivable financing (also known as invoice financing), that can be used to boost working capital. These financing methods are particularly valuable for companies who are looking to invest in short-term growth opportunities or build resilience against external market risks.
How does accounts receivable factoring work?
An accounts receivable factoring arrangement involves three parties: a seller business (or supplier), a customer, and a factor. The exact details of the accounts receivable factoring process depend on the factor’s specific approach, but it tends to work like this:
The supplier, after fulfilling orders placed by the customer, contacts the factor, and submits the invoices they want to receive payment for. The factor pays a set amount of the total invoice value to the supplier immediately and collects contact details for the customer. They then contact the customer to inform them of the accounts receivable factoring arrangement if they don’t already know.
The factor is then responsible for the invoice collections process and receives the full invoice amount from the customer in direct payment on or before the invoice maturity date. Once they’ve received the money from the customer, they settle the outstanding balance with the supplier, minus a small fee, which they keep for their services.
The accounts receivable factoring process
Step-by-step, the accounts receivable factoring process described above looks like this:
- The seller business submits a set of unpaid invoices to the factor. Generally, they can submit as many or as few of their unpaid invoices as they’d like.
- The factor pays a cash advance for the invoices, typically between 70% and 90% of the total invoice amount. They retain the remainder of the invoice value as collateral.
- The factor takes on responsibility for the collection of the full invoice amounts from the seller’s customers and receives payments at the invoice maturity dates.
- The factor pays the remainder of the invoice value to the seller’s business, minus their factoring fee.
Accounts receivable factoring vs accounts receivable financing
Accounts receivable factoring is similar to accounts receivable financing in lots of ways. This is because they’re both forms of receivables finance – an umbrella term that describes all types of financing that involve collecting cash against accounts receivable.
However, there are some key differences between the two receivables financing methods that mean they offer unique pros and cons.
The key difference is in the nature of the transaction between the supplier business and the factor. In accounts receivable factoring, the supplier sells its invoices to the factor, completely offloading ownership and responsibility for them. In accounts receivable financing, invoices are simply used as collateral to secure what is, in essence, a loan.
This has relatively obvious ramifications on how the two financing methods work. The payment collections process remains the responsibility of the supplier in a financing arrangement, for example, since they still own the invoice. Naturally, that means the supplier business also continues to hold the risk of unpaid invoices turning into bad debt.
However, accounts receivable financing arrangements do offer some benefits over factoring. Chief among them is the fact that the arrangement can be kept confidential from customers since the financer doesn’t have any involvement in the collections process.
The table below summarizes the key differences between accounts receivable factoring and financing:
|Accounts receivable factoring
|Accounts receivable financing
|Selling of AR to a factor at a discount in exchange for immediate cash.
|Using AR as collateral to secure a loan or line of credit.
|Ownership of AR
|Factor takes ownership of AR.
|Business retains ownership of AR.
|Responsibility for collections
|Factor is responsible for collecting payments from customers.
|Business continues to handle collections and customer relationships.
|Risk of bad debts
|Factor assumes the risk of bad debts and non-payment by customers.
|Business remains responsible for bad debts and non-payment risk.
|Customers are notified of the factor’s involvement in collections.
|Business maintains direct interaction with customers.
|Factoring arrangement may be disclosed to customers.
|Financing arrangement can be kept confidential from customers.
|Cost and fees
|Factoring fees can be higher due to services provided by the factor.
|Financing charges may include interest rates and fees.
Benefits of accounts receivable factoring
Accounts receivable factoring offers a range of potential benefits to businesses, including the following:
Immediate working capital boost
he single most important benefit of accounts receivable factoring is that it offers businesses the chance to get an immediate influx of cash. It allows them to avoid waiting out 30- or 60-day customer payment terms, meaning they can put more working capital to use more quickly.
This cash can be used to fuel business growth, invest in more inventory, build resilience, or something else entirely. And since the value of outstanding accounts receivable can represent up to 24% of a business’s monthly revenue, factoring has the potential to contribute meaningfully to short-term liquidity.
Flexibility in financing arrangement
Accounts receivable factoring is one of the more flexible business financing options. Perhaps most notably, it allows businesses to decide how many of their invoices to factor on a case-by-case basis, meaning they can maximize the value of the arrangement according to their specific financing needs.
Separately, accounts receivable factoring agreements are generally quick to set up, don’t require collateral, and are low on contractual limitations.
Outsourced collections process
Since the factor in an accounts receivable factoring arrangement takes on full responsibility for the payment collections process, the supplier business gets to reclaim some time to spend on other value-driving activities.
There are plenty of better ways for an accounts receivable team to spend their time than on chasing near-due customer payments, including building a better accounts receivable reporting system that allows them to refine their strategy.
No credit involvement
Accounts receivable factoring is not a credit arrangement – the factor buys the unpaid invoices outright rather than lending against them as collateral. That means AR factoring arrangements don’t incur debt on the balance sheet, and they have no impact on credit.
This quirk can be particularly valuable for smaller businesses with sub-optimal credit scores or histories, giving them a financing option that won’t be prohibitively costly.