Accounts Receivable Factoring: Definitions, Pros and Cons, and Alternatives

What is Accounts Receivable Factoring? How it Works ; Accounts receivable factoring is a funding option where a company can sell its outstanding receivables to a factoring company, and the business receives cash.

Kelly Boyer SagertUpdated August 17, 2022

Share this article:

Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.

Accounts receivable factoring, also known as invoice factoring or business receivable factoring, is a method of business financing that companies sometimes use to help manage cash flow and meet expenses. Factoring receivables involves a different process than taking out a bank loan, but the general goal for both is often the same: to provide the business with needed cash.For clarity, here’s a brief definition of the meanings of some terms we'll use throughout this article.

Company or business: the B2B company/business that wants to get funding to meet financial needs
Customer: an invoiced customer of the company/business
Factoring company or factor: a lender that provides financing through the invoice factoring process

What Is Accounts Receivable Factoring?

Factoring accounts receivable is a method of financing that B2B companies that invoice their customers and vendors could consider when they’re in need of quick cash. Basically, the business gets a loan from a factoring company using its accounts receivable as security. Typically the factoring company will give the business a percentage of its outstanding invoices (the advance percentage, which is typically around 80%). When the invoices are paid by the customers, the factoring company gives the remaining 20% to the business, but subtracts a factoring fee.

How Does Factoring Accounts Receivable Work?

The simplest way to answer this question may be to give an example. Here’s a basic illustration to show how the process can work.Let’s say that your business has issued $20,000 in invoices that haven’t been paid yet. Let’s also say that your business will be $10,000 short in meeting payroll if those payments aren’t made on time. To address the situation, your business might decide to factor receivables in order to get enough cash in to pay your employees. This would involve selling the unpaid invoices to a third-party factoring company (or “factor”). At this point, the factor would own the invoices and your business would receive a certain percentage of the dollar amount on them. This is called the “advance rate.” The advance rate that your business would receive would be based on how risky the transaction is for the factoring company.The difference between the dollar amount on the invoice and the amount your business gets upfront is held in reserve until the invoices are paid. Once your customers have paid them, the remainder is forwarded to your business, minus the factoring fee, which the factor keeps. To give some numbers to the example, let’s say that your business qualifies for an advance rate of 80%. To meet payroll expenses of $10,000, you decide to factor $15,000 out of your $20,000 in outstanding receivables. The factoring company would then issue you 80% of the value of the receivables being factored ($15,000 x 80%): $12,000. You could then use $10,000 of the funds to pay your employees and have $2,000 left over for miscellaneous expenses.The next step is for your customers to pay their invoices in full (that money goes to the factor, not directly to your business). Then the factoring company will release the reserve amount (in our example, 20% of the invoice amount or $3,000) minus the factoring fee charged by that particular factor.That is the answer, in a nutshell, to the question of “What is factoring receivables?” Dollar amounts of transactions can vary, based on outstanding invoices and the cash flow needs of the business.

How Are Factor Fees Calculated?

A factor may consider a number of things to determine what factor fee to charge your business. It might look at the industry your business is in, how many invoices are involved, and your customers’ payment histories, as well as at your company’s financials to determine what factor fee to charge you.That said, typically these fees run from 1% to 3% of your invoices, but may go as high as 5%. Bear in mind that you might have to pay a flat factor fee for each week, say, that an invoice goes unpaid—2% the first week, 2% the second week, and so on. But some factors charge a tiered factoring fee, meaning that the amount of your fee can go up if the invoice isn’t paid right away. So while the factor fee might be 2% the first week, for example, it might rise to 3% the next week.

Pros and Cons of Accounts Receivable Factoring

Even companies that focus on cash management strategies sometimes need an influx of cash—and, for some of them, invoice factoring can be a good solution. Just as with other forms of small business financing, though, there are pros and cons to accounts receivable factoring. Benefits may include the following:

No collateral is required, other than the invoices.
You can typically access the cash quickly.
Factoring can help your business manage cash flow.
Lenders typically focus less on the business’s or owner’s credit score and more on the creditworthiness of the customers owing on the invoices.
Some factors will work with startups.
Funds provided by a factor can typically be spent in any way the business desires, with no restrictions.
The factor company takes over collecting on the invoices, freeing up your business to handle other tasks.

Cons of accounts receivable factoring can include the following:

Rates can be relatively high. Plus, there can be a variety of fees, including application, processing, and service fees, which means that factoring can be a more expensive way of getting business funding. This can be especially true if the invoiced customers don’t pay on time.
The factoring company has control of the invoices after your business sells them. That’s why it’s important to choose a factor that will treat your customers fairly and with respect.
If customers don’t pay the invoices that were factored, your business may need to pay for those invoices, along with added fees.
If a business’s customers aren’t creditworthy, then it may be difficult to factor accounts receivable from them.

What a factor charges will depend upon many different things besides the creditworthiness of the invoiced customers, including how old the invoices being factored are; their due dates; and more. Just as with banks that make loans, it’s important to compare what different factoring companies would charge.Recommended: Understanding Debt Factoring for Small Businesses

Recourse Versus Non-Recourse

These are two different factoring models. When a factor uses a “recourse” approach, this means that a company would be responsible for any factored invoices that its customers didn’t pay. When factors are using a non-recourse approach, there can be exceptions to this rule if certain conditions are met. For example, if an invoiced customer files for bankruptcy within a defined window of time or goes out of business, the business might not be held responsible for its invoices. Non-recourse factoring companies may charge a higher fee because they’re taking on more risk.

Choosing the Right Factoring Company

Just as with any lender, you should check out factoring companies that you might want to work with carefully to make sure they’re trustworthy.

Is it registered in your state?
Does it have good reviews online?
What is its Better Business Bureau ranking?
Does it specialize in specific industries? (Some factoring companies work with very specific industries, such as medical or freight transport, while others are more general.)
What are its rates and advance percentages?
Is there a minimum number of factoring transactions required each month?
If there are no minimum requirements, will factoring a certain amount of invoices each month provide your company with a discount?

Once you settle on a factoring company, the factor will then conduct due diligence on your business and on the customers whose invoices may be factored. After that review is satisfactorily completed, the factoring company will offer an agreement that should be carefully reviewed. Check the interest rate and fees, including whether there is a cancellation fee. See if any minimum factoring amounts are listed; whether there’s a contract term that you’re agreeing to; and so forth.

Alternatives to Accounts Receivable Factoring

Cash flow is often called the life’s blood of a business. A business can look good on paper, with enough money owed to cover expenses. But, if customers don’t pay their invoices in time for a company to pay its own expenses—and the company doesn’t have cash reserves to tide itself over—then cash flow problems can occur and the company might find itself unable to pay its bills. Accounts receivable factoring is one way to handle the problem. But there are others, too.Freeing Up Cash Flow. Ways to free up cash flow include turning invoices into cash more quickly, perhaps by offering early pay discounts to customers and/or asking for a deposit when orders are made. Companies can provide customers with invoices promptly and then follow up on any that go past the due date. If a particular customer has a pattern of paying late, the company could consider switching to cash on delivery with them. Business Line of Credit: Getting a business line of credit from a bank or other lender gives you access to a certain amount of funding decided upon by the lender that you can draw on at will. Interest is charged only on unpaid balances. Business lines of credit are typically revolving credit that replenish how much you can draw as you pay back whatever you owe.Online Business Loan: Online lenders frequently provide loan options similar to those of a traditional bank. However, typically online lenders have a faster approval process. What’s more, they may offer more options for business owners with lower credit scores.

The Takeaway

Accounts receivable factoring is just one way to come up with funds for your small business quickly. And, depending on your situation, it may or may not be the best way for you. It’s always good to know your options as you’re making important financial decisions, whether it’s for you or your business.As you’re looking for funding for your small business, it can be helpful to compare the loans that are available to you. At Lantern, you can compare small business loans from multiple lenders easily online. Having all the information at your disposal can help you make the best decision for your small business as you move forward.

SOLC21041

About the Author

Kelly Boyer Sagert

Kelly Boyer Sagert is an Emmy Award-nominated writer with decades of professional writing experience. As she was getting her writing career off the ground, she spent several years working at a savings and loan institution, working in the following departments: savings, loans, IRAs, and auditing. She has published thousands of pieces online and in print.

Share this article: