Your guide to accounts receivable factoring

Drake Grey of Bowtie Marketing has a story that is familiar to many small business owners: “I was constantly checking my mail looking for checks that would pay the immediate bills. My clients would always pay, but their delayed payments meant that I was constantly delaying my rent. I occasionally had to tell employees, ‘I’m sorry, but I have to delay your paycheck.’ That’s hard.”

Drake didn’t need a long-term loan, he needed short-term cash to smooth out the “feast or famine” cycle. Then he found his solution: invoice factoring. Says Grey: “I didn’t even realize how much stress this was causing until I had cash to operate and the stress was gone.”

Invoice factoring has been around in some form since Babylonian times. Otherwise known as “accounts receivable financing,” “invoice factoring,” or “receivables factoring,” invoice factoring companies help businesses match cash flow to their expenses.

What is accounts receivable factoring?

Factoring is a method of turning your invoices — which are customer promises to pay at a later date — into cash immediately. You get paid by the factoring company, and the factoring company then gets paid by your customer.

Here’s a normal transaction you’re familiar with:

  1. Small Biz Inc provides a product or service to Big Biz Inc.
  2. Small Biz then issues an invoice for that product or service to Big Biz, which will pay 30 days later
  3. Small Biz scrambles to make payroll and pay expenses since it hasn’t yet been paid
  4. Big Biz pays Small Biz 30 days later

With invoice factoring, the basic elements of the transaction remain the same, but the small business gets cash faster:

Diagram of who pays whom in factoring

Here, the factoring company streamlines the transaction by speeding up the cash to the small business.

The benefits of accounts receivable factoring

The obvious benefit is that if you have customers who will pay you in 7-90 days, you can “pull” that cash flow forward to use today.

However, there are additional benefits to factoring versus other financing types.

  • Speed: Factoring companies can put the cash in your bank within 24 hours – and some can do this same-day via a wire transfer.
  • Save time and hassle: A bank’s process requires lots of paperwork and time for small business loan, but most factoring companies can get you a decision and money within several days, and with less paperwork.
  • 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 amount of invoices a business has. The business’ credit line can increase naturally as the business grows and builds its relationship with the invoice factoring company.
  • No debt: Factoring is an advance on payment that is already coming to you, not a loan, so it does not appear as debt.
  • Increase your credit score: If your factoring company reports to a credit agency, factoring invoices will boost your credit score in addition to removing the cash flow management stress.
  • Outsource accounts receivable and collections: Depending on how hands-on your factoring company is, they might remove some administrative burden of dealing with accounts receivables and potentially even collections on delinquent invoices.

How factoring can help a small business

To understand how factoring can help a growing business, let’s follow Claire’s story:

Example of how factoring works


What type of business should (and shouldn’t) factor invoices?

For a quick, interactive guide to choosing the best type of financing for your small business, see “5 Questions to Find Your Optimal Small Business Financing.”

There is only one requirement for invoice factoring: having invoices. This means that businesses of all sizes use invoice factoring, including Fortune 500 companies.

Factoring tends to help businesses that have a mismatch between when cash comes in and when expenses are due. For example, for a manufacturing company to fulfill a big contract it will have a big expense (materials) before it has big income (when the invoice is paid). Or consider a commercial landscape service company which pays for gas and payroll during the month, but is only paid at the end of every month. Here are a few more reasons to use factoring:

Reasons to factor

Some industries in particular that frequently factor are

  • Freelancers (marketing, PR & creative)
  • Staffing companies
  • Distributors
  • Small manufacturers
  • IT services and software development
  • Shipping and transportation
  • Construction and contractors

The details:

Because factoring is not actually a loan and because there is an extra company involved (the customer), there are a few details unique to factoring:

Factoring terms and descriptions

How does AR factoring compare to other types of financing?

For more on this topic, see 5 Questions to Find Your Optimal Small Business Financing.”

How to work well with your factoring company

The primary risk to factoring companies is fraud. If you want to keep your access to financing open and not deal with penalties, strengthen your relationship with your factor by keeping the following in mind.

  • Don’t factor invoices from bad customers: If you know a customer may not pay, then you will ruin your relationship with your factor and (assuming it is a standard full-recourse factor) they can come after you for the money.
  • Be upfront about bad news: If you factored what you thought was a good invoice and you find out that your customer will be late to pay, tell your factor. Having those tough conversations will go a long way toward demonstrating that you are trying to work with them, and they will be more likely to work with you.
  • If you use factoring with notification, communicate this to your customer.  This makes the notification process much easier and will start your relationship with your factoring company on a good note.

How to choose a factoring company

Before you go looking for a factoring company, know what you want. Will you factor from time to time, or all of the time? Do you want the flexibility to quit factoring or change factors if something goes wrong, or are you willing to risk big penalties by signing a long-term contract? Are you willing to build an Excel model to calculate your cost from a factor with lots of fees, or do you prefer the peace of mind of a factor that has one simple rate and minimal fees? Below are a few questions to ask to make sure you have the full story when choosing a factoring partner:

  1. What is your fee structure? Depending on the industry and the factor in question, some factors, like Bluevine, only charge a flat weekly or monthly fee for their service, which is a percentage of the total invoice value. Other factors may seem to have lower rates, but charge additional fees. Also consider what the transparency – or lack of transparency – may mean for the long-term relationship.
  2. Do you require a long-term contract? Some factors require that you factor all invoices from a company for a period, generally one year – and have hefty penalties if you leave early. Others offer “spot financing,” or the ability to factor individual invoices. This allows small businesses to try out invoice financing and see if it works well with their business’ needs.
  3. Is there a minimum factoring requirement? Many factors have minimum requirements: you must factor $20,000 every month or face penalties, etc. While this may help you get a lower rate, it may also mean you are forced to incur factoring fees when you don’t actually need the cash.
  4. Are you recourse or non-recourse? Most factors are “full recourse,” which means that you must pay back the advance if your customer never pays their invoice. “Non-recourse” means that once you factor an invoice, you don’t have to worry about your customer paying – but it is riskier for the factor, and thus usually more expensive for you.
  5. How much do I need to factor? Different factoring companies offer different credit line sizes. The size of the invoices and the total credit line you want will determine which factoring companies are candidates for your business.

For more information on this topic, see How to Pick a Factoring Company.

The cost of factoring

Factoring is a short-term advance, but many business make the mistake of comparing it to long-term loans. Many business owners focus on Annual Percentage Rate (APR), which is a good metric for long-term debt like a credit card balance, a mortgage, etc. But APR is a poor metric for factoring because you never use factoring on an “annual” basis.

When thinking about factoring, it is important to keep in mind what we are comparing the cost to. In other words, what are our alternatives?  Here are three scenarios that compare factoring to different alternatives:

Factoring vs. alternatives

In addition, there are all sorts of other costs from not factoring, including:

  • Late fees. Are you getting hit with late fees for rent, etc.? Those late fees usually represent very high equivalent interest rates.
  • Morale. Are you sometimes holding employee paychecks? How much is that hit to employee morale and productivity costing you? What happens when a star employee leaves?
  • Your time and energy. As a business owner, your most valuable resource is time. Worrying about your cash flow doesn’t add any value to your business, but how much time is it taking every month? What if you reinvested that in finding new clients or training your employees?

In Summary

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