31 Jan 2024

Understand Accounts Receivable Factoring: A Guide

Subhasis Sahoo (Founding Member - Marketing)

What is Account Receivable Factoring?

Accounts receivable factoring is a financial transaction where a business sells its outstanding invoices (receivables) to a third party, known as a “factor,” at a discount. In exchange for the immediate cash advance, the factor collects payment from the business’s customers and retains the discount. It’s akin to getting paid today, albeit with a small fee for the privilege.

Types of Factoring:

  • Recourse factoring: The business remains responsible if the customer doesn’t pay. This option typically comes with lower fees.
  • Non-recourse factoring: The factor assumes the credit risk of the customer. This offers security but comes at a higher cost.
  • Full factoring: The factor handles all collection activities and assumes credit risk. This provides the most convenience but is the most expensive.
  • Spot factoring: The business sells individual invoices instead of a whole portfolio. This offers flexibility but may be less cost-effective.

How does Account Receivable Factoring work?

  • Initiation: The business selects a factor, submits invoices for approval, and agrees on terms.
  • Advance payment: The factor pays the business a percentage (usually 70-90%) of the invoice value, minus a factoring fee.
  • Collection: The factor collects payment from the customer, either directly or through the business.
  • Settlement: Once the customer pays, the factor remits the remaining invoice value to the business, minus any additional fees or adjustments.

Calculating the cost:

The cost of factoring is expressed as a factoring rate, typically a percentage of the invoice value. This rate can be calculated in various ways, but a common method is the “effective annual rate” (EAR).

EAR = (Factoring fee / Advance amount) x (365 / Invoice days) x 100%

Benefits of Account Receivable Factoring:

  • Improved cash flow: Factoring injects immediate cash into the business, easing short-term financial constraints and boosting working capital.
  • Reduced risk: By assuming credit risk in non-recourse factoring, the factor takes the burden of bad debts off the business’s shoulders.
  • Enhanced collections: Factoring companies have expertise and resources to efficiently collect outstanding invoices, reducing collection time and bad debts.
  • Increased flexibility: Factoring offers financial agility, allowing businesses to seize opportunities or invest in growth without waiting for customer payments.
  • Improved creditworthiness: On-time payments facilitated by factoring can improve a business’s credit score, making it easier to secure future financing.

Is it right for you?

Factoring is not a one-size-fits-all solution. It’s best suited for businesses with long credit terms, slow-paying customers, or limited access to traditional financing. However, the cost can be significant, so carefully consider the fees and evaluate alternative options like bank loans or lines of credit before pursuing factoring.

Technical takeaways:

  • Accounts receivable factoring is a financial tool that converts outstanding invoices into immediate cash.
  • Different types of factoring offer varying degrees of risk and cost.
  • The process involves selling invoices to a factor, receiving an advance payment, and the factor collecting from the customer.
  • The cost of factoring is calculated using the effective annual rate (EAR).
  • Factoring offers several benefits, including improved cash flow, reduced risk, and increased flexibility.

Remember, factoring is a powerful financial tool, but it’s not without its costs and risks. Carefully assess your needs, compare options, and negotiate terms to ensure factoring unlocks its true potential for your business. Talk to an expert now.