Accounts receivable factoring is a financial transaction where a business sells its outstanding invoices to a third-party company, known as a factor. This process, often called invoice financing, allows the business to receive cash immediately rather than waiting for customers to pay.
For companies that need to improve cash flow management or secure short-term financing, accounts receivable factoring provides a vital solution by converting unpaid invoices into immediate working capital solutions.
By extending credit in B2B transactions, businesses build trust and expand their customer base. However, these credit sales create accounts receivable—assets representing future payments. When a business needs cash sooner than customers are scheduled to pay, it can partner with a factoring company.
The factor pays the business a large percentage of the invoice value upfront and then collects the payment directly from the end customer, enhancing the business's financial stability.
Accounts receivable factoring isn't a one-size-fits-all solution. The agreements typically fall into one of three categories:
1. Recourse vs. Non-Recourse Factoring: This defines who is liable if a customer fails to pay an invoice.
Recourse Factoring: The factoring company can "recourse," or collect, the funds back from your business if the customer defaults. Your business ultimately absorbs the loss, making it a common choice for companies with low credit risk.
Non-Recourse Factoring: The factor assumes the risk of non-payment. According to data from the a financial industry report, this added security makes non-recourse agreements a preferred, though more expensive, option for businesses in volatile industries.
2. Notification vs. Non-Notification: Factoring This describes whether the customer is informed about the factoring arrangement.
Notification Factoring: The factoring company informs the customer that it has purchased the invoice and provides new instructions for making payment.
Non-Notification Factoring: The customer is not aware of the factoring agreement, which helps maintain the appearance of in-house collections.
3. Regular vs. Spot Factoring: This refers to the scope of the relationship, sometimes distinguished as debt factoring.
Regular Factoring: An ongoing agreement where the business continuously factors invoices up to a set limit.
Spot Factoring: A one-time transaction where a business sells a single invoice or a small batch of invoices, often used by businesses with occasional cash flow gaps.
Because factoring is a form of small business financing, there are associated costs. The formula involves a few key components:
First, the factor determines the advance rate. This is the percentage of the invoice’s total value that the factor pays your business upfront, typically between 80-90%. The rate depends on the age of the invoices and the creditworthiness of your customers.
Second, the factor applies fees. As detailed by financial experts at [High-Authority Finance Site, e.g., Investopedia], these often include:
Discount Fee: The primary cost, similar to an interest rate, usually ranging from 1% to 5%.
Service Fee: An additional charge for administrative tasks.
The basic formula can be expressed as:
Factoring Amount = (Total Invoice Value x Advance Rate) – Factoring Fees
Businesses use factoring for several strategic reasons. The primary motivation is to receive cash immediately instead of waiting 30, 60, or 90 days for customer payments. This is especially useful for companies with irregular payment cycles or those needing upfront capital.
Factoring also helps businesses manage credit risk. By outsourcing collections, internal teams can focus on core operations. In a non-recourse agreement, the business also transfers the risk of customer default to the factoring company, creating greater financial stability.
BlackLine’s Cash Application solution can help manage accounts receivable factoring and other aspects of the cash conversion cycle. By leveraging AR automation, businesses can eliminate manual processes and gain control over the end-to-end invoice-to-cash process.
Schedule a demo with us to find out how BlackLine’s software can streamline your working capital solutions.
The primary benefit of accounts receivable factoring is the immediate improvement of a company's cash flow. Instead of waiting weeks or months for customer payments, a business receives instant liquidity by selling its invoices. This allows the company to consistently cover operational expenses like payroll, purchase inventory, and invest in growth opportunities without delay. Ultimately, it provides financial stability and flexibility by converting future revenue into present-day working capital.
The cost of accounts receivable factoring typically ranges from 1% to 5% of the total invoice value. This rate is influenced by factors such as the transaction volume, your customers' credit history, and the length of the payment terms. The total cost is composed of a discount fee, which is similar to an interest rate, and a service fee for managing the collections process.
No, accounts receivable factoring is not a loan; it is the sale of a financial asset. Because the transaction is a sale of your invoices, it does not add debt to your company's balance sheet. This is a key advantage over traditional financing, as it preserves your borrowing capacity for other needs. The process simply converts one asset (accounts receivable) into another (cash).
The process involves five steps:
1. You provide a service.
2. You send the invoice to the factor.
3. The factor advances you up to 90% of the invoice value.
4. The factor collects payment from your customer.
5. The factor pays you the remaining balance, minus their fee.
Factoring is used by a wide range of B2B companies, especially in industries with long payment cycles like manufacturing, transportation, and staffing.
To see how the costs of factoring are calculated, consider an example in which a business has an unpaid invoice of $100,000.
The factoring company it applies to for a cash payment offers an advance rate of 80 percent combined with a discount fee of two percent and a flat service fee of $500.
In this example, the first step of the factoring formula would be calculated to determine how much will be loaned to the business:
Advance amount = (Invoice X .80) = $100,000 X .8 = $80,000
When the invoice is ultimately paid by the customer, the factoring company will calculate the remaining steps in the formula to determine what it is owed by the business.
It will repay itself for the initial payment of $80,000, and the business will receive the remaining balance with adjustments. The remaining balance will be calculated by subtracting the advance amount from the original invoice total:
Remaining balance = $100,000 - $80,000 = $20,000
Adjustments will be calculated by subtracting the discount and service fees from the remaining balance:
Adjustments = $20,000 - (.02 + $500) = $20,000 - ($1600 +$500) = $17900
The amount that the business receives equals the advance amount plus the adjusted remaining balance, which will equal a sum that is slightly less than the total value of the original invoice:
$80,000 + $17900 = $97,900 < $100,000
As compensation for its lending services, the factoring company will have earned the total of its discount and service fees, or $2100.
Accounts receivable factoring may be confused with another type of transaction that involves the value of unpaid invoices. Accounts receivable financing describes a type of loan that a business receives by using the unpaid invoice as collateral.
The business repays the loan with the proceeds it receives as invoices are paid. Like factoring, it is a way for a business to generate cash that can be applied to other facets of the business.
Unlike factoring, it is strictly a loan and the lending company has no involvement in the collection of payment from customers.
When a company factors its receivables, it treats the transaction as a sale of assets, removing the invoices from its balance sheet. This increases cash and decreases accounts receivable, while the factor's fees are recorded as an expense against income. If the agreement is with recourse, the company must also disclose a contingent liability for the risk of customer non-payment.