Factoring: Account Receivable Financing

Factoring, or account receivable financing, allows businesses to access money locked up in accounts receivable. Factoring allows businesses to sell outstanding invoices to financial groups at a discount, allowing quick access to unpaid accounts that might otherwise take up sixty days to receive.

If you are beginning a small business, it's imperative to understand how factoring works, and how it can help your cashflow, particularly if you are in a financial bind.

A financial loan involves two parties: the borrower and the lender. In contrast, a factoring agreement involves three parties:

The factor buys invoices at a discount and may refuse to purchase accounts receivable that are owed by clients with poor creditworthiness.

As an extra protection, the factor also charges a reserve fee, intended to cover late payments or shortfalls in payment. If the debtor pays off invoices in a timely manner, the seller is either refunded the reserve fee, or the reserve is credited to the sellers account for future account receivable financing.

Factoring handles possible payment defaults in several ways other than reserve fees. Some factors take on the risk of default payments when they purchase invoices. Other factoring organizations purchase accounts receivable with the understanding that the seller will buy back invoices in the event of nonpayment.

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Accounts receivable financing is not a bank loan, although the financial institution involved may be a bank. Factoring refers to the sale of outstanding invoices. No payments are made, nor is any interest charged. Factoring is the outright sale of accounts receivable invoices to a third party, usually a financial company that specializes in accounts receivable financing.

Why would a business sell invoices at a discount rather than wait for payment to arrive? Many companies give customers forty to sixty days without interest to pay their invoices.

The customer is effectively extended credit for this time period, during which the company is unable to access capital in accounts receivable. Similarly, the company can't earn any interest on the capital. Businesses that need immediate access to funds locked in accounts receivable find it worthwhile to lose a small amount of capital through selling invoices at a discount.

Account receivable financing can also be used to help businesses in financial difficulties. A common scenario involves a business that has extended bank loans and lines of credit to the limit.

In this scenario, factoring allows the company quick access to the finances it needs to stay afloat. While a bank loan takes time to process, account receivable financing usually provides the company with capital within two or three days.
 
Companies in distress use factoring often enough that account receivable financing is often thought of as last-ditch emergency financing. This is true to the extent that factoring is an option for companies with financial shortfalls, but account receivable financing is also used when a company has no financial emergency.

In addition to transforming unpaid invoices into accessible credit, some companies favor factoring as a way to move money from the accounts receivable side of their balance sheet to the positive side of the sheet. The advantage, of course, is that the more funds the business can access, the more attractive it looks to investors.

Factoring can be of tremendous help to a company, particularly in cases where payment of accounts receivable invoices can be expected to extend to sixty days or longer. There are, however, times when accounts receivable financing is not the way to go.

In cases where invoices for sales or services is only slightly more than the cost incurred by providing the service, factoring is not the best choice for a business, as the discount charged by the account receivable financing company may make factoring unprofitable.

Resources

1^st Commercial Credit (n.d.). Business Factoring. Retrieved March 1, 2008 from the 1^st Commercial Credit Web site:
www.1stcommercialcredit.com/business-factoring/.

Hennessey Capital (n.d.). Accounts Receivable Services. Retrieved March 1, 2008 from the Hennessey Capital Web site:
www.hennesseycap.com/ar_financing.html.

ING (n.d.). Accounts Receivable Financing: A Planning Strategy for Professionals. Retrieved March 1, 2008 from the Financial Professionals Group Web site:
www.fpgonline.com/carriering/ING%20Acounts%20
Receivable%20Consumer%20Guide.pdf.