What is Accounts Receivable Factoring?

Accounts receivable factoring is a solution that allows business owners to quickly turn invoices into working capital. Instead of waiting for weeks or months for customers to pay their invoices, accounts receivable financing lets business owners get an advance on those invoices and use the cash for pressing business needs instead of waiting for weeks or months for customers to pay their invoices. It’s especially ideal for businesses that have long net terms but have ongoing operational expenses or new expenses that help propel growth.

How to Factor Invoices

Factoring is a form of financing that begins after your business provides goods or services to creditworthy customers. Upon completion of service, your business would follow the steps below:

  1. Your business invoices a customer and sends a copy to the factoring company
  2. The factor then funds your business with an advance typically between 70% to 90% of the invoice amount
  3. Your business gets the remaining invoice amount, minus a small fee, once the customer pays the invoice.

Let’s follow Claire’s story to understand when a business could use invoice factoring.

How invoice factoring helped Claire

In this case, Claire was able to take on a new customer thanks to invoice factoring. But there are other situations where factoring invoices makes sense, too.

Accounts Receivable Factoring Benefits

Accounts receivables financing/factoring is perfect for business owners who typically handle a lot of invoices, need funds quickly, and are waiting for payment from their customers.

Common uses include:

  • Providing cash liquidity without taking on debt
  • Fueling business growth when new opportunities arise
  • Solving short-term everyday working capital crunches due to uneven cash flow
  • Maintaining inventory or materials for on-going or new projects

Benefits Of Accounts Receivable Factoring

Factoring Can Build Your Credit Profile

Factoring can help businesses, especially younger ones, build (or rebuild) a positive business credit history. As long as your business maintains a strong repayment record with your factor, your factoring provider can report it to a credit agency, which in turn will gradually boost your business credit score. Not all factoring companies report to business credit agencies, so check with them before you sign with one of them.

TIP: There are three major ways to build your business credit score: doing business with vendors that will report your payment history to credit agencies, making early payments to credit bureaus, and getting credit cards that report payment history to commercial credit agencies.

Factoring Can Help Companies Survive A Downturn

Every business goes through cycles – even great businesses have good and bad years. This can be due to a downturn in an industry, a serious economic crisis, or even an issue unique to a specific business, such as product recalls or lawsuits.

Traditional finance companies are more reluctant to lend to businesses when they’re in a down cycle. It’s very typical for these traditional financing partners to cut a business’s credit off as soon as the business hits a downturn — which inadvertently worsens the situation.

Factoring companies are more concerned with the creditworthiness of a client’s customers, and not just on the strength of the client itself. That’s why even when a business hits a rough patch or has a bad year, a receivables financing company can continue to stand strong and be a reliable source of capital.

Factoring Lets You Pursue Market Opportunities

Now, you must also know this: factoring can be more expensive than other traditional types of financing, such as bank loans. But there’s an advantage to the convenience and flexibility factoring offers. With factoring, a business can actually improve its margins.

Vendor discounts can offset some or all of the cost of the factoring. Furthermore, the additional capital can be used by the company to take advantage of unique opportunities in the marketplace such as bulk inventory purchases at discounted prices or equipment being sold at fire-sale prices.

The greater access to capital provided by factoring can allow a company to take advantage of opportunities that it would have otherwise missed and to ultimately be more profitable.

How Much Does Accounts Receivable Financing Cost?

Invoice financing costs largely depend on three factors:

  1. Rate: Most factoring fee rates range between 0.5% to 5% of the invoice amount per month. The fee rate is usually determined by the quality of your customers, the number of customers you have, your industry, and your business financials amongst other things. As a general rule of thumb, the more invoices you factor, the lower your fee rate tends to be.
  2. Service Length: The length of your net terms also comes into cost consideration. The shorter the time you take out financing for, the cheaper the total fee since fee rates are charged in percentages on a weekly or monthly basis.
  3. Additional Fees: Even if you are offered a low fee rate, you should be on the lookout for any additional fees that may be outlined in your factoring agreement.

Accounts Receivable Cost Example

Imagine you have a $10,000 invoice which is due in 30 days. You decide to factor this invoice because you need to purchase equipment to take on a new project.

The factoring company has a discount rate of 2% per month. Their terms state that you will get 90% of the invoice cost immediately and the remaining amount of the invoice when once your client makes full payment.

So, you receive an advance of $9,000 to purchase equipment and keep your business growing. Then, once your customer pays in 30 days, you will get $800 back which is the remaining invoice amount ($1,000) minus the 2% discount rate ($200).

In this example, the total cost of factoring is $200.

When To Use Accounts Receivable Financing

When You Want To Take On Bigger Jobs Without Incurring Debt

Many businesses make the mistake of looking at financing as an expense instead of as an investment – in growth, in employee morale by meeting payroll, etc.

Here’s an example:

Your company has an opportunity to make $10,000 on a job, but it will cost you $8,500 in supplies and payroll upfront to do the job. You don’t have this cash, so you have to pass on the job – unless you factor an existing $8,500 invoice for 4 weeks at 1%/week.

 Finance receivablesPass on the job
Potential earnings$1,500$0
Subtract the cost of factoring1% x $8500 x 4 weeks = -$340$0
Net earnings$1,160$0

In this case, saying 1% per week is “too expensive” means you lose the opportunity to grow your business by $1,160 even after the cost of factoring.

When You Don’t Qualify For A Bank Loan

When determining a financing offer, most traditional lenders care about the performance of each business individually. But factoring is an exception—it allows businesses to leverage the strength or the creditworthiness of their clients when they apply for financing. That’s why if a business has a low credit score, insufficient bank history, or negative bank balances, they still may be able to receive financing from a Factor because Factors will consider the quality of their customers’ creditworthiness, reputation, and business history.

When You Need More Than One Source Of Capital

Some factors are able to provide you with additional funds on top of the existing financing you may have. However, this is entirely dependent on your business’ needs and financial situation—for example, if you have collateral coverage, a factor may be able to fund behind your bank. But please note that not all factors are able to guarantee this form of financing arrangement.

TIP: Your collateral coverage ratio is calculated by the asset you use for collateral. It’s an important metric for lenders to determine how much they are able to lend you. The higher your ratio, the higher the risk is for your lender.  

In Summary

Invoice factoring is the optimal solution for a business looking for a solution to fill short-term cash crunches and need funding for growth. To find the best factoring company, make sure you understand your business’ needs, ask the right questions, and be careful of getting locked into contracts and hidden fees.

Now that you have a comprehensive understanding of accounts receivable factoring, you’re well on your way to finding the right factor for your business. If you’d like to speak to a representative about BlueVine’s Accounts Receivable Factoring service, give us a call at (888) 216-9619.

Appendix

Common Invoice Factoring and AR Financing Terms To Be Familiar With

Understanding factoring vocabulary can help make sense of the options.

 What it isWhat it means for you
Full recourseIf your customer doesn’t pay, the factor can come back to you and ask you repay the advanceOnly factor invoices from customers you know will pay.  This will keep a good relationship with your factor and prevent a bad surprise for everyone involved
Reserve accountSome factors skim a little off each invoice to build a “reserve account” that is insurance for them: if one of your customers doesn’t pay, they charge it to your reserve account. If you leave your factor, then they give you this cash back.If your factor uses a $10,000 reserve account, that is $10,000 of your cash that is useless to you until you terminate your relationship with your factor.
Reserve amountOften confused with “reserve account,” this is simply the % of the invoice held back until your customer pays — usually 10-15%Generally, lower is better: this gives you more cash to use upfront
RebateThe amount paid to you when your customer pays the invoice; this is the reserve amount minus feesIncentives are aligned: you and the factor both want your customer to pay
VerificationA “spot check” way for the factor to prevent fraud: behind the scenes, the factoring company will verify that an invoice is real and the customer has the right payment addressVery little impact – the customer is “blind” to fact that a factor is involved
NotificationThe factor legally notifies the customer that payments should be made to the factorYour customer now knows about your factoring relationship. A good factor will have a smooth process in place to notify your customer.

Additional Benefits Of Online Invoice Financing Companies

The benefits below generally apply to online invoice financing companies, not traditional factors.

  • Save time and hassle: A bank’s process requires lots of paperwork and time for a small business loan, but most factoring companies can get you a decision and money within several days and with less paperwork.
  • Speed: Factors can put the cash in your bank within 24 hours – and some can do this same-day via a wire transfer.
  • Poor or no credit is OK: Businesses with poor credit can get funding even when they don’t qualify for other types of financing since factoring is based on the quality of your customers’ credit —  not only your own credit or business history.
  • Your bank balance doesn’t matter: Small businesses can get funding since factoring provides a line of credit based on sales, not your company’s current cash.
  • Flexible financing amount: The amount available through factoring is only limited by the number of invoices a business has. The business’ credit line can increase naturally as the business grows and builds its relationship with the factor.
  • No debt: Factoring is an advance on the payment that is already coming to you, not a loan, so it does not appear as debt.
  • Increase your credit score: If your factor reports to a credit agency, factoring invoices will boost your credit score while simultaneously removing the stress of closely managing cash flow.

Disclaimer: The information and insights in this blog post are provided for educational purposes only, and do not constitute financial advice from BlueVine. Please consult your financial advisor before making any business financing decision. For information about BlueVine products and services, please visit the BlueVine FAQ page.