Accounts Receivable Factoring: Definition and Requirements
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Depending on the financial situation of a business, its leaders may not want to wait for the money that's held up in accounts receivable. Accounts receivable factoring is a common way for businesses to make money from their unpaid invoices while they wait for the customer to pay. This type of transaction allows a business to capitalize on the goods or services that it has already provided. In this article, we discuss what accounts receivable factoring is, how much it costs and the requirements for receiving this type of loan.
What is accounts receivable factoring?
Accounts receivable factoring is a type of transaction where a company buys a business' unpaid invoices and then collects payment on them from the customer. Factoring companies, which are organizations that specialize in this type of transaction, typically pay the business a large percentage of the invoice amount upfront and then pay the rest, minus their fees, once the customer pays. This type of transaction can benefit businesses with poor credit ratings, as their credit score isn't a factor in the transaction.
There are two main types of accounts receivable factoring: recourse and nonrecourse. Recourse factoring allows the factoring company to recoup its costs from the invoice's original owner if they can't collect the full amount. This type of factoring is less risky and usually comes with lower fees. Nonrecourse factoring is when the factoring company assumes the risk that they will not be able to collect the full amount and may result in a smaller payout for the owner.
How much does accounts receivable factoring cost?
The percentage of the invoice that the factoring company pays back to the owner can depend on a few variables. Here are some elements of accounts receivable factoring that can affect the price:
The industry of the business that owns the invoice
The factoring company may charge different fees depending on the industry of the invoice owner. For example, a research and development company might take a long time to pay off an invoice since it could take longer for its project to make money. In this case, a factoring company might charge a higher percentage of the invoice amount. Retail companies that handle goods may take less time to pay the invoice, so the factoring company may offer a more favorable rate.
The credit score of the customer that owes on the invoice
Although factoring companies don't consider the credit of the invoice's owner, they do account for the credit of the customer. If the customer that owes money on the invoice has a bad credit score, the factoring company may consider the invoice high-risk and offer a smaller percentage of the payout to the owner. In contrast, if the customer has good credit, the factoring company may offer a greater percentage of the payout with fewer fees.
The type of accounts receivable
When a factoring company buys an invoice that is nonrecourse, they're accepting the risk that they may not be able to recover the full amount. In this case, the factoring company can't charge the original owner the differences. Because of the increased risk, factoring companies usually pay a much smaller percentage on nonrecourse invoices. When the company purchases an invoice with recourse available, the factoring company can get their money back from the invoice owner should they be unable to collect, so the risk is much less.
The number of accounts receivable being purchased
Sometimes factoring companies choose to buy accounts receivable invoices in bulk. They typically pay a smaller percentage for each, as they are assuming more risk with a large number of unpaid invoices. Despite the risk, this can still be a beneficial exchange for the factoring company, particularly if they have recourse available on any unpaid accounts included in the bundle.
What are the requirements for accounts receivable factoring?
While accounts receivable factoring may be helpful for some businesses, it's not always an option. Here are some elements that factoring companies consider before buying invoices:
How long the company has been in business: Factoring companies often consider how long the company that owns the invoices has been in business before deciding to purchase their accounts receivable invoices. A factoring company might see a business that has been open for many years as a more favorable and stable option.
Who owes money on the invoices: Factoring companies don't buy invoices that private individuals owe. Government agencies or other business entities need to owe the invoice in order to qualify for accounts receivable factoring.
What invoicing practices does the company use: Factoring companies typically perform an audit of the business' invoicing practices before agreeing to the transaction. Factoring companies usually require that the invoice owner has detailed histories of each invoice, as well as records of sales, timelines and other relevant financial information about the subject of the invoice.
Accounts receivable factoring vs. accounts receivable financing
Instead of selling their invoices, a business may also decide to finance them. Accounts receivable financing is a loan that uses the recipient's invoices as collateral. This type of loan is useful for companies that need cash quickly. Financing companies assess the value of a company's invoices, as well as their quality and likelihood of being paid, and then offer a cash loan secured by the invoice's value. Once the invoices have been paid, the recipient company then repays the loan to the financing company with any additional charges or fees they have incurred.
The key difference is that with accounts receivable factoring, the factoring company is responsible for recovering the amount due on the invoices. With accounts receivable financing, the finance company offers a loan, but the recipient company holds the responsibility to recover payment on invoices. A financing company may offer more favorable rates because they don't need to recover the payment. Financing companies may also look at the business' credit score and other relevant financial information to determine if they qualify for a loan.
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