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Explaining Accounts Receivable Factoring
All companies need access to credit in order to support their inventory, meet payroll and pay their day to day operating expenses. Unfortunately, given the current economic downturn, credit has become so tight that most companies have but few financing options remaining. However, there is one option that has allowed companies to weather this current economic storm. It’s called accounts receivable factoring. So, what exactly is accounts receivable factoring and how can it help businesses deal with an uneven cash flow and lack of available credit?
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Why Do Companies Use Accounts Receivable Factoring?
Accounts receivable factoring allows companies to raise much needed funds when facing a credit crunch (such as the one we are currently facing in this down economy). In addition, companies often use factoring because of a lack of customer payments, when facing an uneven cash flow, or even when they are faced with declining customer demand due to seasonality. Companies can otherwise be perfectly healthy, and indeed thriving, but still need to use accounts receivable factoring. It is not an indication of a company’s health. In fact, in some cases, the rates on factoring are more favorable than any business loan or credit line.
The most common industry that uses factoring is the housing construction industry. This industry often faces issues with cash flow, despite having considerable equity tied up in outstanding unpaid customer invoices. For some companies, the issue is the standard payment terms within their given industry. It’s not uncommon for companies to give customers net-90, or even net-120 day terms, but be forced to pay their own invoices within 30 days. Suffice it to say, there are many reasons why companies use factoring. However, the question remains, how does factoring work and what, if any, options are there?
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How Does Factoring Work?
Accounts receivable factoring involves a company using its unpaid customer invoices as credit, or collateral, with a factoring company. In a sense, the company is selling its customer’s unpaid invoice to a finance company in exchange for immediate access to a portion of the invoice’s value. The factoring company will provide an up-front payment to the company. The amount paid varies from 75% to 85% of the invoice’s value. Afterwards, the factoring company will then proceed to collect on the full value of the invoice from the customer. Once the amount is paid in full, the factoring company deducts their fee, and returns the remaining 25% to 15% back to the company.
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Recourse Factoring & Non-Recourse Factoring
Most financing companies offer two factoring options to their clients. These two options are referred to as recourse & non-recourse factoring. When companies are interested in using factoring, they must be able to weigh the good and bad of both options.
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How Does Recourse Factoring Work?
When companies opt for using recourse factoring, they are essentially guaranteeing that their customer will pay the invoice’s full value. If the customer doesn’t pay, the company itself is responsible for reimbursing the factoring company the entire amount drawn. Because the company is guaranteeing its customer will pay the invoice, the finance company may be willing to pay out a larger initial payout. In this case, it’s the company that is assuming all the risk and not the factoring company. As such, most factoring companies will provide a higher initial payout and lower transaction fee.
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How Does Non-Recourse Factoring Work?
In non-recourse factoring, it’s the factoring company that assumes the risk. Because of this, the initial payout is often lower and the company may be forced to pay a higher transaction fee. The finance company adjusts their payout and fees to coincide with their level of risk. Most factoring companies measure the health of the customer, their ability to pay, and the overall health of the market or industry.
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What Are the Pros and Cons of Factoring?
One of the immediate drawbacks of factoring is that the finance company itself will collect directly from the company’s customers. If not properly managed, customers may feel apprehensive and concerned about their vendor’s financial health. Therefore, it’s imperative that customers be made aware of why the company is using factoring. Other issues pertain to the impact on gross profit when using factoring. There are transaction fees that can reduce the return on sales and erode the value of the invoice.
When looking at the benefits of factoring, it’s important to recognize that accounts receivables factoring is a great way to generate immediate financing. As previously mentioned, in many instances the transaction fees with factoring are far more competitive when compared to the interest rates on business loans and business credit lines. In some instances, companies may no longer want to deal with a specific customer. Factoring then allows them to make a clean break, without having to chase for payment.
When using accounts receivable factoring, make sure to review the different options available. There are benefits and drawbacks to both options. In addition, if your company wishes to continue to work with this specific customer, make sure to explain why your company has decided to use the factoring company.
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