Accounts Receivable Factoring: What, How, Benefits, and More (+examples)

Introduction

Waiting for weeks or even months for payments on outstanding invoices can strain your financial resources, impeding your business expansion efforts. This is where accounts receivable factoring can help. How?

Accounts receivable factoring enables you to sell your receivables at a discounted rate to a third party, known as the ‘factor.’ In return, you receive immediate cash, which helps address your working capital needs. Rather than waiting for your customers to clear their invoices, you can swiftly access funds through factoring.

In the following section, we’ll explore what accounts receivable factoring is, its types, how it works, and benefits. But before we dive into the details, let’s briefly touch upon how effective cash flow management is vital for businesses.

What Is Accounts Receivable Factoring

Accounts receivables factoring is a financial practice where a company sells its invoices to a third-party financial institution at a discount for immediate cash. The factor collects payment from customers, and the company receives funding without waiting for payment or taking on additional debt.

As you explore the world of accounts receivable factoring, it’s important to understand the key factors that influence the amount you receive for your invoices. Here are the conditions that impact the factoring process:

• Invoice Amount: The total value of the invoice plays a role in determining the factoring amount.
• Expected Payment Time: The estimated time it takes for your customer to clear the invoices affects the factoring evaluation.
• Customer Creditworthiness: The creditworthiness of your customer is considered to assess the risk involved in the factoring transaction.
• Collection History: The track record of your company in collecting receivables can influence the factoring terms.
• Due Date: The due date of the accounts receivable affects the factor’s evaluation of the invoice.
• Industry Considerations: The industry your company operates in is taken into account as it may influence payment trends and risks.

Based on these factors, the factoring company determines the discounted rate at which they purchase your receivables. This rate can range from as high as 4% to as low as 1%, depending on the specific conditions mentioned above.

Types of factoring

When it comes to receivables factoring, there are different types available based on specific business needs. Let’s explore the various types of accounts receivable factoring:

1. Recourse vs. non-recourse factoring:

   Recourse factoring means the business retains responsibility for unpaid invoices, while non-recourse factoring shifts the risk to the factoring company. Recourse factoring has lower fees and higher cash advances, while non-recourse factoring offers less risk but higher costs.

2. Notification vs. non-notification:

   Notification factoring involves informing customers that their invoices have been sold to a third party, with payments made directly to the factoring company. Non-notification factoring keeps the sale confidential, allowing businesses to continue collecting payments from customers.

3. Regular vs. spot factoring:

   Regular factoring involves selling a batch of invoices at once, providing ongoing financing for businesses with consistent invoicing. Spot factoring allows businesses to sell a single outstanding invoice, ideal for occasional large invoices or specific transactions.

Each type of accounts receivable factoring has its benefits and considerations. Understanding these different types of accounts receivable factoring options helps businesses choose the most suitable approach based on their specific needs. Now, let’s delve into how accounts receivable factoring works and the step-by-step process involved.

How Does AR Factoring Work?

To make it simple to understand the process of accounts receivable factoring, let’s break it down into simple steps:

Step 1: Submission of Invoices

You submit your invoices to the factoring company for verification. They assess the eligibility of the invoices for factoring. Typically, the factoring company advances 80 to 95 percent of the invoice value on the same day. For instance, if the factored amount is $10,000 and the agreed advance rate is 90%, you would receive $9,000 upfront.

Step 2: Segregation of Resources

The factoring company retains the remaining percentage (usually 8-10% of the total invoice value) as security until the payment is made by the customer. This amount serves as a deposit and is held by the factoring company.

Step 3: Collection of Payment

Over the next 30 to 90 days, the factoring company takes charge of collecting the payment from your customers based on the agreed-upon payment terms.

Step 4: Final Payment to the Seller

Once the payment is received by the factoring company, they deduct their fees and the retained amount, typically ranging from 1% to 3% of the total invoice value. The remaining payment is then released to your business.

Understanding the step-by-step process of accounts receivable factoring helps you grasp how it can provide immediate cash flow by converting your outstanding invoices into working capital. Now, let’s move on to the next section and explore how to calculate accounts receivable factoring.

How to Calculate AR Factoring?

Calculating AR factoring is a straightforward process that helps you determine the amount of funding you can receive from a factoring company. Before we dive into the calculation, it’s important to understand the key components involved. These include the total invoice value, the advance rate, and the factoring fee.

Factoring accounts receivable formula

Funding Amount = Total Invoice Value x Advance Rate – Factoring Fee

Let’s break it down step by step:

1. Total Invoice Value: Start by determining the total value of the invoices you want to factor. This is the sum of all the outstanding invoices you plan to submit to the factoring company.
2. Advance Rate: The advance rate is the percentage of the total invoice value that the factoring company will advance to you upfront. It typically ranges from 80% to 95% depending on various factors such as the industry, creditworthiness of your customers, and the terms of the factoring agreement.
3. Factoring Fee: The factoring fee is the cost charged by the factoring company for their services. It is usually presented as a percentage of the total invoice value or as a discount rate. This fee covers the factoring company’s administrative costs, credit risk, and financing services.
4. Funding Amount: Using the formula mentioned earlier, multiply the total invoice value by the advance rate. Then subtract the factoring fee to arrive at the funding amount, which represents the cash you will receive from the factoring company.

Factoring accounts receivable example

Let’s assume you are Company A, which sends an invoice of $10,000 to a customer that is due in six months. You decide to factor this invoice through Mr. X, who offers an advance rate of 80% and charges a 10% fee on the amount advanced.

Using the formula we discussed earlier, let’s calculate the funding amount:

Total Invoice Value: The total invoice value is $10,000.

Advance Rate: Mr. X offers an advance rate of 80%, so the calculation would be: $10,000 x 80% = $8,000.

Factoring Fee: The factoring fee is 10% of the amount advanced, which is: 10% of $8,000 = $800.

Now, let’s determine the funding amount:

Funding Amount = Total Invoice Value x Advance Rate – Factoring Fee

Funding Amount = $10,000 x 80% – $800

Funding Amount = $8,000 – $800

Funding Amount = $7,200

Therefore, the funding amount you will receive from Mr. X is $7,200.

On the due date, Mr. X collects the payment of $10,000 from the customer. After deducting the factor fees ($800), Mr. X will pay back the remaining balance to you, which is $1,200 ($10,000 – $800). As a result, Company A receives a total of $9,200 ($8,000 + $1,200) from its receivables instead of the full invoice value of $10,000.

What Are the Benefits of Accounts Receivable Factoring?

Till now, you must be clear that AR factoring allows you to convert outstanding invoices into immediate cash, providing the working capital you need to keep your business operations running smoothly. However, that’s not the only benefit it offers. Let’s further explore the benefits of receivables factoring and its potential positive impact on your business.

1. More Feasible than Loans: Sometimes people mix up receivables factoring with traditional loans, but they are actually quite different. Factoring doesn’t require collateral or impact your business’s credit rating. It’s a flexible solution that provides immediate working capital when you need it most.
2. Improvement in Cash Flow:Cash flow is crucial for any business’s success. However, when your revenue is tied up in unpaid invoices, it can slow down your cash flow and create difficulties in meeting payroll and covering overhead costs. With accounts receivable factoring, you can say goodbye to waiting for invoice payments. It swiftly converts your outstanding invoices into cash, ensuring a steady cash flow to keep your operations running smoothly.
3. Building Business Capital: One of the great things about factoring is that it doesn’t affect your business’s credit ratings or borrowing rates. It’s not a loan, which means you can access the cash you need without worrying about its impact on your creditworthiness. This influx of working capital can boost your revenue and help you build up a reserve for future growth and investment opportunities.
4. Keeps the Business in Control: Taking loans from banks often puts businesses in the “high credit risk” category. It comes with collateral requirements and recurring monthly payments that can strain your cash flow, especially during slow sales periods. Accounts receivable factoring, on the other hand, provides a simpler and more transparent approach. You remain in control of your finances without the burdensome collateral and monthly payment obligations associated with loans.
5. Outsourcing Accounts Receivable Management: Factoring companies often handle accounts receivable management tasks, including verification, collection, and credit checks. Outsourcing these tasks saves time and resources, allowing businesses to focus on core operations.

Conclusion

Cash flow issues can significantly impact the growth and profitability of your business. To avoid this issue, you need to ensure that you receive payments from customers on time. And to do that, it is crucial that you manage your accounts receivable well. However, managing accounts receivable is not easy, especially if you do not have a robust collections team in place.

Accounts receivable factoring can act as a valuable solution for businesses that may not have a robust collections team in place. By leveraging factoring services, businesses can improve their cash flow and increase overall revenue while avoiding the risks associated with traditional loans. This strategic approach provides businesses with an effective means to enhance cash flow, fortify financial stability, and sustain growth.

With HighRadius’ Autonomous Receivables solution, you can eliminate the bottlenecks and inefficiencies that often plague manual accounts receivable processes. It enables businesses to automate tasks such as invoice generation, payment reminders, dispute resolution, and cash application. Through leveraging machine learning and artificial intelligence, the platform optimizes collections strategies and provides real-time insights into customer payment behavior.

Don’t let cash flow challenges hinder your business’s potential. Take control of your accounts receivable processes with HighRadius’ Autonomous Receivables solution and maximize your cash flow. Schedule a demo today!

FAQs on Accounts Receivable Factoring

• What is the average cost of accounts receivable factoring?

  The average cost of accounts receivable factoring ranges from 1% to 5% of the invoice value. However, costs can vary based on factors such as customer creditworthiness and the volume of invoices. To get the exact cost details you can contact factoring companies.

• What is the main purpose of factoring accounts receivable?

  The primary purpose of factoring accounts receivable is to provide businesses with immediate cash by converting unpaid invoices. This assists in improving cash flow, meeting financial obligations, and supporting business growth without relying on traditional loans or collateral.

• 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.

• How does factoring receivables work?

  Factoring receivables is when a company sells its unpaid invoices to a factor for immediate cash. The factor advances a percentage of the invoice value and takes over the responsibility of collecting payment from the customers. This improves cash flow and eliminates the wait for customer payments.