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Accounts Receivable Financing (Factoring) Explained

A/R Funding is an excellent source of capital for businesses that are growing or experiencing a temporary cash flow squeeze.

Accounts Receivable Funding also known as factoring is the sale of invoices at a discount. A method of financing that is used by businesses to raise capital quickly and improve cash flow without going into debt.

How Does it Work?

Precisely, when a business sells a product or service to a customer, it creates an invoice. Typically, an invoice would itemize the unit sold, the price, and the terms of the sale. The invoice can either serve as a receipt if it acknowledges that payment has been received, or as a bill if payment is due. An outstanding invoice may also be called an account receivable. Instead of waiting to collect payment, a business may elect to sell the invoice to a factor and receive immediate cash advance. A factor is an individual or business that is engaged in the buying of accounts receivable.

A Typical Factoring Process

1) You deliver goods or services and create an invoice.

2) Sell the invoice to Factor per contract.

3) The Factor verifies your invoice.

4a) The Factor funds you up to 80%-90% of the invoice immediately.

4b) The balance of 10%-20% is held in a reserve account.

5) The Factor collects payments on the invoice from your customer.

6) The Factor funds the balance of the reserve account (10%-20%) less the agreed upon fee. 

For the privilege of receiving immediate access to money and early payment, you will be charged a nominal factoring fee by Factor. Your customer will be notified of where to send payment. The fee for the factored invoice will be deducted after payment is received from your customer. You do not have to factor all your invoices or change your billing process except for the payment address, and in some cases, Factor will have to submit the original invoices to your customer.

Factoring fills the money gap and creates a predictable and dependable source of cash. Instead of waiting on payments from your customers for uncertain number of days, weeks, and sometimes months, funds can be made available immediately by Factor each time you invoice. You would now have available cash to meet payroll, pay rent, buy supplies, and meet other operational needs.

The Factor will wait to collect from your customer. When the invoice is paid, Factor will retain a sum equal to initial cash advance plus applicable fees. The balance is then refunded to you along with account statements. The exact factoring fee will depend on volume and time of payment.

With factoring, a business owner might be able to completely avoid loans and other financing options that could restrict independence and the ability to operate freely and efficiently.

Until recent decades, factoring was only available to large corporations that are able to meet the minimum threshold required by major Factors, many of which were wholly-owned by or subsidiaries of banks. Today, factoring is available to small and medium-sized businesses because factors and brokers that are more diverse, and requiring no minimums or maximums has entered the field.

To begin a factoring relationship, you will submit an application along with documents to support your business registration, ownership, and possibly sales volume. Afterwards, you will sign an agreement that may include UCC filing statements, IRS information release forms, and other documents. In most cases, no term commitment is required and your credit limit will be directly related to sales. The process can take anywhere from 3 – 10 days to establish an account. After which, funding is often immediate, usually within 24 – 48 hours of submitting an invoice. It does not particularly matter in what State you are located.

Factoring has evolved into a very fine financing technique for companies that are experiencing rapid growth or have other cash flow needs but may not qualify or want conventional funding.

There are countless reasons why businesses factor. For example: you may need a continuous level of cash to give you the ability to operate in a timely and efficient manner; you may want an unlimited credit line that is directly related to sales; you may want an alternative to borrowing without encumbering valuable assets; you may want to extend terms to your customers to make it easy for them to pay and encourage them to buy more; you may want immediate access to your money rather than waiting on your customers to pay and so on.

Perfect credit is not required to establish a factoring account. The single most important requirement to qualify for factoring is that you must be a registered business and have accounts receivable due by credit-worthy customers. It is the Factor’s responsibility to verify your customer’s credit worthiness.
You can qualify whether you are a start-up or an already established and profitable business with credit problems and even if you already have a loan or line of credit.

Because factoring sources are very diverse, several approaches may be used. However, there are two major types of factoring – Recourse and non-recourse. Recourse factoring requires a personal re-purchase guarantee by the seller, who is ultimately responsible for unpaid, disputed, and fraudulent invoices. With non-recourse factoring, the Factor assumes total risks provided the invoice is not disputed. Regardless of what type of factoring, all agreement requires principal’s guarantee against committing fraud.

Operationally, there is also factoring with notification and non-notification. Factoring with notification is where a seller’s customer is notified by the factor and verifies the invoice. With non-notification factoring, the seller’s customer is not notified and may not be aware of the factoring relationship.

After the agreement is signed, a UCC-1 lien against all accounts receivable is filed. It is a blanket lien, and it is similar to a lien on a house, which is against the entire home and not just parts of it. Accounts receivable is simply looked at as one of the assets of a business.

Generally, most factors will gladly provide references and testimonials from satisfied clients. However, they do so sparingly only to serious prospects and with the consent of their clients, so as not to violate confidentiality agreement.

The following are some of the prevailing misconceptions about factoring:

Misconception #1: Factoring is only suitable for large corporations or businesses that are in extremely bad financial condition.

Fact: Although, it is true that factoring used to be the exclusive domain of corporate giants. The fact is, by share numbers alone, more small businesses than big corporations are factoring today. Almost any business can receive funding through factoring and the rates are very competitive. Factoring is also not just
for companies experiencing cash shortages. Most astute business managers use it in long-term planning and in conjunction with other revenue generation methods. It is increasingly becoming part of businesses overall Financial Plans.

Misconception #2: Customers may hold a negative view of your company if you factor, and may seek alternative vendors.

Fact: Being able to qualify for outside funding should speak bundles to your confidence and the confidence financiers have in your company and your customers. Business owners more than anyone understands the difficulty nowadays in securing outside
funding. To have access to funds when you need it should put your customers at ease because you will be better equipped to meet their needs at any time even on short notice. Therefore, they would prefer to continue working with you rather than seek another vendor to start a new relationship with. Moreover, approval to
factor is usually based more on the credit-worthiness of your customers than your personal credit.

Misconception #3: Factors offend and alienate customers with collection calls.

Fact: A factor’s goal is to enable you to do increasing and continuing business. Therefore, it is in a factor’s interest to help you succeed. It’s folly to think that factors would intetionally offend and harass your customers with collection calls. The other facts are that without direct pressure factors more often improve and enhance the collection process to the amazement of clients. This is so because most businesses realize that their ability to secure more accounts can be directly related to their credit reports and references. The report factors may provide to Commercial Credit Bureaus may impact the ability of your customers to do business. Therefore, in order to have and maintain good credit rating, they will pay on time.

Yes, I would not deny the fact that factors do and sometimes call customers, but only as a reminder, rather than to harass a customer. Factors are more likely to successfully resolve payment issues in ways that would satisfy the client than the client would on their own.

Misconception #4: Factoring is prohibitively expensive and would absorb all profit margins and put you out of business.

Fact: Last but not least, that factoring is too expensive is often a generalized response given when a prospect does not yet have complete details. The cost of factoring is relatively favored compared with other financing. It can vary greatly and depend on many conditions, not unlike bank loans.

Factoring is simply another form of financing that businesses have. Factor’s funding should not be weighed against a bank loan because funds received through factoring is not considered a loan legally or in practice. The fee is not considered as interest, it is a purchase discount.

Attempting to multiply and annualize the discount rate may be well intentioned, but it is misleading.

If you borrow $100,000 from a bank at 12%, you could make monthly payments of $1,000 and in 12 months would have paid $12,000. Yet, you would still owe $100,000. If you factored $100,000 each month at 5% discount, in 12 months your fees would be $60,000. However, you would have received $1,200,000 (12 x 100,000) and the fees would still be $60,000.

What factoring does is like converting your invoice terms to COD (cash-on-delivery). For being able to receive substantial upfront payment, you allow a discount. The real bottom line is that with better cash flow you can grow your business rapidly and exponentially. In theory, your profit should increase, not decrease. For example, take the case of a T-Shirt design and distribution company that does about $8,350 in sales monthly or $100,200.00 a year without the benefit of factored revenue. However, with cash advance to buy supplies and meet expenses, revenue could possibly double.

Even with increased expenses and cost of factoring as a result of additional volume, you would get a much higher percent of profit overall. Net profit increased from $4,008 or 4% to $27,054 or 13.5%. This is still a significant increase. The core question is, can you do more business with better cash flow? Fixed cost and overhead would not necessarily increase in proportion to sales. You may increase staff, but because your sales double does not mean you have to double overhead such as — office space, utilities, or labor.

Most businesses would prosper with better cash flow. However, it takes more than just money to run a successful business. It would be irresponsible of us to make claims of how profitable you will be. How much profit you can make would depend on a number of factors. It would require knowledge of your business, your
skills, abilities, and so on, which is out of our control. Numbers used here are for illustration purposes only. We make no guarantees that you will achieve the same results.

Now that you have complete information about factoring, we hope that you are better equipped to make an informed decision. However, we are not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, you should seek the services of a competent
professional person.

Please contact us at 877-836-4661 for further information.

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