What Is Receivable Factoring? (Plus Pros and Cons)
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Maintaining a company's cash flow is an important part of sustaining a business. Accounts receivable factoring is a financial transaction that helps businesses exchange receivables for an improved cash flow. Learning more about accounts receivable factoring can help you better understand the financial structure and sustaining strategies of a business. In this article, we review what accounts receivable factoring is, the difference between recourse and non-recourse factoring, pros and cons of using it as well as examples.
What is accounts receivable factoring?
Accounts receivable factoring is when a business sells its accounts receivables to a financial company, or factor, in exchange for cash flow. Accounts receivables are due amounts to a business, usually consisting of customer credit due amounts that are unavailable to the business as actionable funds.
Companies may factor accounts receivables to improve cash flow rather than waiting on credit dues from customers. Because a cash payment helps a business sustain more projects than gradual flow from accounts receivables, businesses may invest in accounts receivable factoring to help improve budgets, pay for expenses or prepare for impending costs.
Factoring companies charge a factoring fee during the process. A factoring fee is a percentage of the amount of receivables the financial company factors. Factoring fees can increase or decrease depending on factors such as industry, the volume of receivables, the creditworthiness of customers and the average days outstanding of receivables.
Recourse factoring vs. non-recourse factoring
Another element of receivable factoring is the differences between recourse and non-recourse factoring. There are some differences between the two that impact the factoring business, including:
Transfer rates differ depending on if the receivable factoring is recourse or non-recourse. Recourse factoring transfer means that the financial company can demand money back from the business in the event that the financial company can't collect payment from receivables customers.
Non-recourse factoring is the opposite. If a receivable factoring is non-recourse, the financial company can't request capital in return for nonpaying customer credit, making the business that received capital in exchange for receivables free of liability from uncollectible receivables.
Factoring fees may increase depending on if the receivable factoring is recourse or non-recourse. If an exchange is non-recourse, the financial company may incur more factoring fees as interest in the event that multiple receivables eventually become uncollectible.
If both businesses agree to allow recourse, however, the exchange may be more liable to have fewer factoring fees. Additionally, if a business' customers have high creditworthiness, the business may be able to incite less factoring fees even in a non-recourse agreement.
Pros and cons of receivable factoring
There are many potential benefits and disadvantages of receivable factoring, both for the factoring business and the receiving company. The pros and cons of receivable factoring are as follows:
Disadvantages of receivable factoring
Some disadvantages of receivable factoring include:
When exchanging capital for receivable factoring, financial businesses can charge service fees of up to 4% of the exchanged amount. This can be more than many other business loans and can decrease the overall flexibility of finances during the decision.
However, because a company receives immediate capital upon exchanging receivable factoring, the utility a business has with newfound capital can enable more cost-saving measures to handle those fees.
Additionally, if the capital amount is high, using capital for more projects may be able to improve productivity and profit enough to accept transfer fees without issue.
During receivable factoring, financial businesses take the responsibility of customer credit dues. If enough customers don't pay the credit they owe to the financial business, the financial business can account the company liability for lost fees.
However, in the event of a non-recourse exchange, a financial business can't hold a company liable for unpaid customer fees. If a business believes that customers may not repay credit on receivables, accepting a higher transfer fee in exchange for making a non-recourse agreement can help the business both receive capital and free of any liabilities concerning the customer.
Financial institutions can be reliable repeat clients for receivable factoring, but not if the process doesn't go well for both parties. If financial institutions have difficulties receiving payments from a businesses' customers, it may make it difficult for the business to perform receivable factoring with the entity again.
When considering receivable factoring, consider the customer's average creditworthiness and fees beforehand. If a business can ensure the financial entity does not lose funds from the transfer, both businesses may be able to benefit from the transaction and have reliable transactions in the future.
Advantages of receivable factoring
Some advantages of receivable factoring include:
When a business exchanges receivables for capital, the business gains more capital. Getting increased cash flow as quickly as possible is important for businesses because cash flow allows business leaders to fund projects, improve processes and accept new hires.
An influx of capital in comparison to an unsteady rate of receivables payments is a great exchange for a business that needs extra funds for a short period of time. Businesses can use increased funds to cover impending costs, manage debt and replace equipment.
Lowered credit risk
If a business exchanges receivables for capital, they allocate all credit risk with those receivables to the receiving company. Only in the event of a recourse receivable factoring can a business account liability for loss of funds.
If credit payments proceed as planned, however, a business can potentially gain increased capital with little financial variance in less time. Additionally, because the receivables become the responsibility of the financial company after transfer, any payment difficulties are also not the responsibility of the former business. This aspect alone can help the business save time, money and effort during transactions.
Improved business control
The capital that a business receives from exchanging receivables can help it become more flexible concerning changes within the company. For example, if a business has slowed progress on a project or improvement, such as building another area of the headquarters, the sudden influx of capital can help the company realize such financial needs. Increased capital can also give businesses the freedom to invest in other aspects of the market, such as a new industry or product.
Examples of accounts receivable factoring
To better understand accounts receivable factoring, review some of the following examples:
Rivergreen Tech transfers $600 million of receivables without recourse. In response, the financial company repays Rivergreen with proceeds of $500 million. With an interest expense of $100 million, the financial company receives $100 million immediately through fees and expects $600 million in receivables over time. As a result, Rivergreen receives $400 million in usable capital after insurance fees. Because the transaction is non-recourse, even if the customers don't repay the financial company, Rivergreen can't become liable for unpaid income.
Greenriver Inc needs $200 million for an outstanding project, but currently does not have the available capital. They offer a $400 million recourse receivable factoring exchange to a financial company. In response, the financial company pays Greenriver $300 million with a $100 million interest fee, and Greenriver accepts.
This allows Greenriver to apply the remaining $200 million of instant capital to the new project. Because the agreement is recourse rather than non-recourse, if the customers of Greenriver don't pay the capital back to the financial company, the company may hold Greenriver accountable to return fees at a later time.
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