Tightened standards on commercial loans and lines of credit in recent years have made everyone a little wary, especially business owners. Customers are requesting extended payment terms on invoices, or in extreme cases, ignoring payment terms and paying on their own schedule. Employees need to be paid, rent needs to be paid, supplies need to be purchased, and the list goes on. If a business wants to expand, owners face even more difficulty. This is where Accounts Receivable Financing, also known as Factoring, comes into play.
What is Accounts Receivable Financing?
Simply stated, it is the sale of a company’s accounts receivable. It occurs when the company sells its receivables for a small fee to an accounts receivable financing company and receives immediate payment, rather than waiting 30, 60, or 90 days to get paid. Accounts Receivable Financing is also commonly known as Factoring.
The factoring process begins with a soft credit check of the debtor followed by a verification of the receivable’s authenticity. Once credit on the debtor is approved and the receivable is verified, it is purchased that same day. The purchase amount of the receivable, called an advance, usually starts at 80% or more.
The factor then collects payment on the receivable from the debtor and submits the remaining amount, called a reserve, to the client, minus a predetermined fee which the factor retains. The fees charged by factors are tiered, typically starting at 1 percent, and can change based on when the receivable is paid. Bottom line: clients can receive up to 99 percent payment on their receivables.
What Parties are Involved?
Factor: The factor is the company that finances the receivables for as much as 99 percent of their face value. The factoring fee is determined by the amount of total receivables to be funded, plus the credit worthiness of the client’s customers.
Client/Seller: The client or seller is the business-to-business company that sells its receivables to be factored. After entering into an agreement with the factor, the client no longer needs to be burdened with managing their accounts receivable.
Debtor/Customer: The debtor is the company to which the receivables are billed. When a client begins factoring, the debtor is notified of the sale of the receivable, and the factor sends the invoice to the debtor.
Non-Recourse Factoring With non-recourse factoring, the factor assumes the credit risk associated with financing the receivables. Credit insurance is purchased by the factor to cover a receivable if it is not paid due to bankruptcy or business closure. This type of factoring protects small businesses from experiencing a financial loss.
Recourse Factoring: With a recourse factoring agreement, the client/seller remains responsible for the receivable if the debtor does not pay the factor. Typically required to be paid within 90 days, the risk associated with the receivable remains with the seller. If a debtor defaults on a receivable, the factor will collect the advance back from the client.
No Debt Incurred
Factoring is not a loan, so a business does not owe the money to anyone. It is the purchase of a financial asset. When a client participates in factoring, they do not have to worry about an outstanding balance.
With factoring, the emphasis is placed on the debtor’s credit and not the client’s credit. While bank loans place a value on the organization’s credit worthiness and assets such as real estate, capital, inventory and accounts receivables, factoring is only focused on the debtor’s ability to pay.
Because factoring is based on the client’s customers’ ability to pay, companies can continue to take multiple customer orders without the risk of overextending their finances. With a small business loan or line of credit, an organization may be forced to delay taking on new business to apply for an increase. Factoring works in parallel with your business, and as your business grows, so does your access to those funds.