Accounts receivable (AR) factoring is a financing solution that has become increasingly popular with businesses struggling with cash flow. AR factoring involves selling outstanding invoices to a third-party company at a discount in exchange for immediate cash. Factoring allows businesses to quickly access the funds they need to manage day-to-day operations. In this article, we’ll define AR factoring, discuss its benefits, describe the types of AR factoring, explain how factoring works, and share the facFtors to consider when selecting an AR factoring company.
Accounts receivable factoring, also known as invoice discounting, refers to the practice of selling receivables to a third party (known as a factor) at a discounted rate in order to obtain cash immediately. Factoring gives businesses quick access to the funds they need to manage operations without having to wait for customers to pay their invoices. Small businesses, startups, and companies with seasonal or fluctuating cash flow often use factoring.
Receivable financing is a type of loan whereby small businesses use their unpaid invoices as collateral to secure funds. The amount they receive is based on the value of the outstanding invoices. Once the invoices are paid, the business repays the lender along with any fees incurred.
In receivable factoring, the factoring company takes ownership of collecting unpaid invoices, and in non-recourse factoring, they bear the losses for invoices that remain unpaid. Receivable factoring is a costlier option than receivable financing.
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Some of the benefits of AR factoring include:
- It provides businesses with an immediate infusion of cash to cover operating expenses like payroll, rent, and inventory or to fund business growth.
- It helps businesses improve their cash flow and saves time spent collecting payments from customers.
- It’s a good option for businesses that are unable to secure traditional financing from banks or other lenders due to poor credit history.
- It typically has few restrictions in terms of how the proceeds are used.
There are three main types of AR factoring:
- Recourse factoring involves the business assuming the risk of non-payment by the customer. If the customer doesn’t pay the invoice in full, the seller must refund the advance payment.
- Non-recourse factoring shifts the risk of non-payment to the factor. Non-recourse factoring is generally more expensive, and it is typically subject to stricter criteria since the factor assumes the risk.
- Spot factoring allows businesses to sell individual invoices on a case-by-case basis rather than committing to a long-term contract.
The process of AR factoring typically works like this: A business sells its outstanding invoices to a factor at a discount (typically 80-90% of the invoice value). The factor then assumes responsibility for collecting payment from the customer. Once the customer pays the invoice, the factor pays the remaining balance, less a factoring fee, to the business.
Let's take a closer look at the step-by-step process involved.
Step 1: Invoice submission
The first step is to submit your invoices to the factoring company for review. Once the company verifies that the invoices meet their criteria for factoring, they will advance you 80 to 90 percent of the total invoice value, often on the same day as submission. The factoring company will retain the remaining percentage of the payment as a security reserve until the invoice is paid by the customer.
Step 2: Payment collection
Over the following 30 to 90 days, the factoring company will collect payment from your customer in accordance with the payment terms.
Step 3: Final payment to seller
Once the factoring company receives payment from the customer, they pay you the remaining balance between the amount you were advanced and the full invoice amount, less fees.
There are several factors to consider when selecting an AR factoring company, such as:
- Industry experience: Partnering with an AR factor that understands the industry your business operates in guarantees seamless execution of the factoring process.
- Pricing: Ensure you choose to work with a factoring company that clearly explains how they charge for their services.
- Customer service and support: Elect to work with a factoring company that provides prompt responses to customer inquiries.
- Flexibility: Choose a factoring company that is flexible in the types of invoices they will purchase.
Another option is to rely on factoring brokers to connect your business to a suitable factoring company. Factoring brokers are experts in invoice factoring and can match businesses that require factoring with a compatible factoring company. Factoring companies compensate brokers by paying them a referral fee for a successful match, so their services are free to businesses seeking factoring services.
AR factoring is an effective financing solution that enables businesses to quickly access funds required to manage operations without having to wait for customers to pay invoices. It offers several benefits, including improved cash flow, time savings, and flexibility in how funds are used. There are different types of AR factoring, such as recourse factoring, non-recourse factoring, and spot factoring. There are several factors to consider when selecting an AR factoring company, and factoring brokers can be used to help businesses find suitable factoring companies. Overall, AR factoring is a useful tool for businesses looking to improve their cash flow and maintain financial stability.