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What is Accounts Receivable Factoring? [Examples & Benefits]

What you’ll learn


  • What is accounts receivable factoring?
  • How does accounts receivable factoring work?
  • Example of accounts receivable factoring

The concept of accounts receivable factoring, also known as invoice discounting, comes into play when a company decides to sell its receivables at a discounted rate to a third party and receives immediate cash in return. The third-party firm is called the ‘factor’.  AR factoring helps accelerate the cash flow by providing quick access to funds, instead of waiting for 30, 60, or even 90 days to get the invoice cleared.

What is accounts receivable factoring?

Accounts receivable factoring is a form of financial management that enables businesses to get immediate cash after selling their receivables to a third-party called ‘factor’. A company uses factoring when it decides to sell its accounts receivable at a discounted rate. After the sale of receivables, the company receives immediate cash.

The amount that a factoring company pays for an invoice, depends on a number of conditions. They are:

  • The invoice amount
  • The expected time that the customer will take to pay the invoices
  • The creditworthiness of the customer
  • Collection history of the company
  • Due date of the accounts receivable
  • Industry the company belongs to

The discounted rates at which the factoring company buys the receivables can go up to 4% and can come down to even 1%, depending on the factors mentioned above.

How does accounts receivable factoring work?

Growth of factoring services market

To help you understand how accounts receivable factoring works, let’s look at a step-by-step break-up of the process.

Step 1: Submission of invoice

After you submit all the invoices to the factoring company, they verify the details and make sure the invoice qualifies for factoring. In most cases, the company advances 80 to 95 percent of the factored amount on the day of invoice submission itself. 

For example, if the factoring company buys $10,000 worth of receivables and agrees to advance 90% of the total payment, then you will receive $9,000.

Step 2: Segregate the resources

The factoring company holds the remaining percentage of the amount as security money until the invoice is paid by the lender. It is mostly 8–10% of the total amount which the factoring company keeps as a deposit.

Step 3: Collection of payment

Over the next 30 to 90 days, the accounts receivable factoring company collects the payment from the customer, depending on the payment terms.

Step 4: Completion of final payment to the seller

After the payment has been received by the factoring company, the factor clears the remaining amount of payment to your business, which is 1%-3% of the total invoice value.

Example of accounts receivable factoring

Value of factoring market in 2021

To better understand accounts receivable factoring, let us take a look at the following example:

Company A sends an invoice for $10,000 to a customer that is due in six months. It also forwards a copy to its factor (Mr. X), in return for $8,000.

On the due date, the factor collects the payment of $10,000 from the customer, and charges a 10% fee on the amount advanced to Company A. It then returns the remaining balance amount to Company A.

Therefore,

  • The amount advanced to Company A by Mr. X= $8,000
  • Factor fees accrued= 10% of $8,000= $800
  • Received invoice amount= $10,000

So, [$10,000-($8,000+$800)]= $1,200

Thus, Mr. X (factor) will have to pay back $1,200 to Company A after deducting the factor fees to settle the entire transaction. Company A, this receives a total of $9,200 ($8,000 + $1,200) from its receivables instead of the full value, i.e, $10,000.

What are the benefits of accounts receivable factoring?

People often see accounts receivable factoring as an alternative to traditional loans. Apart from this, there are a number of other advantages of accounts receivable factoring to business owners.

  1. More feasible than loans
  2. People sometimes confuse accounts receivable factoring with “lending solutions.” AR factoring does not require any collateral. It also does not impact your business’s credit rating. Factoring comes into play only when you require immediate working capital.

  3. Improvement in cash flow
  4. Cash flow plays an important role in the success of a business. The speed of cash flow can get hampered when the revenue of the business is tied up in unpaid receivables, affecting the payroll and overhead costs of the company. In such a scenario, accounts receivable factoring eliminates the need to wait for the conversion of invoices into cash.

  5. Building business capital
  6. Factoring is not a loan and therefore it won’t affect a business’s credit ratings and the interest rates at which they can borrow money, thereby helping businesses have cash in hand. This, in turn, can boost the revenue of the business, through which businesses can build up a working capital reserve for future growth.

  7. Keeps the business in control
  8. Businesses that tend to take loans often from the bank are likely to be categorized under the ‘high credit risk’ category. They have to submit collaterals and make recurring monthly payments, which might affect their cash flow when the sales are low.

    AR factoring is much simpler and transparent compared to taking loans.

Conclusion

Accounts receivable factoring is mostly used by mid-sized businesses that do not have a strong collections team. It helps businesses improve their cash flow which in turn increases the overall revenue without the risks involved with a traditional loan.

Other resources that might help you:

FAQs

Question: Is factoring receivables a good idea?

Yes, factoring receivables is a great idea for those companies that tend to pursue an aggressive growth strategy without taking too many loans. A business can increase its total number of factors, as long as it maintains a healthy credit score.

Question: What is the cost of factoring receivables?

The average cost of factoring receivables is around 1% to 5% of the total invoice amount, depending on a number of variables such as credit score and the total number of invoices to be paid.

Question: What are the two types of factoring?

There are two types of factoring: non-recourse factoring and recourse factoring. Non-recourse factoring is much more expensive for the company as it takes place when the business doesn’t take responsibility for the customer’s payment. On the other hand, recourse factoring takes place when the company guarantees the creditworthiness of the customer and has to pay the advance fee to the factor if the customer fails to pay. So, the factor fees are lower in recourse factoring.

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