How Does Accounts Receivable Factoring Work?

Accounts receivable factoring is a financial transaction where a business sells its unpaid invoices, also known as accounts receivable, to a third-party company called a “factor” at a discount. This arrangement allows businesses to receive immediate cash instead of waiting for customers to pay their invoices. Its core purpose is to enhance a company’s cash flow by converting outstanding invoices into readily available working capital, providing funds for operational expenses, investment, or managing financial obligations.

Understanding Accounts Receivable Factoring

Accounts receivable factoring involves a business exchanging its invoices for immediate capital. An invoice represents a claim for payment for goods or services already delivered to a customer. When a business engages in factoring, it sells these claims for future payment to a specialized financial institution, the factor.

There are three main parties in a factoring arrangement. The “client” is the business that sells its invoices to the factor. The “factor” is the financial company that purchases these invoices and provides the upfront payment. The “debtor” is the client’s customer, the entity that owes payment on the original invoice.

Factoring is structured as a sale of a financial asset, the accounts receivable, rather than a loan. This distinction means the transaction does not add debt to the client’s balance sheet, which can be advantageous for businesses seeking to maintain a healthy debt-to-equity ratio. Factoring is utilized by businesses that extend credit to their customers and face delays in payment, such as those with long billing cycles. Startups, fast-growing businesses, and companies experiencing seasonal fluctuations in cash flow often find factoring a useful tool for liquidity management.

The Factoring Process Step-by-Step

The accounts receivable factoring process begins with an application and agreement phase. A business contacts a factoring company, which conducts due diligence. This review assesses the client’s business operations and evaluates the creditworthiness of the client’s customers.

Once an agreement is in place, the client submits eligible invoices to the factor for funding. These are invoices for goods or services already provided but not yet paid. The factor verifies these invoices with the debtors to confirm validity and ensure no disputes exist.

Following verification, the factor makes an advance payment to the client, typically 80% to 95% of the invoice’s face value. This immediate cash provides the client with working capital for ongoing operations.

In many factoring arrangements, the debtor is notified that their invoice has been sold to the factor and is instructed to pay the factoring company directly. The factor then collects the full payment from the debtor, managing collection efforts, which can free the client from administrative burden.

After the factor collects the full invoice amount from the debtor, the remaining balance, known as the “reserve,” is released to the client. This reserve is the portion of the invoice value held back from the initial advance payment. From this final payment, the factor deducts its fees and agreed-upon charges.

Variations in Factoring Agreements

Factoring agreements vary, primarily impacting risk allocation and communication with the debtor. One distinction is between recourse and non-recourse factoring. Under recourse factoring, the client retains responsibility if the debtor fails to pay the invoice. If the debtor does not pay, the client may need to buy back the unpaid invoice or provide a substitute.

Conversely, non-recourse factoring means the factor assumes the credit risk if the debtor cannot pay. If an invoice becomes uncollectible due to the debtor’s financial default, the factor cannot seek repayment from the client. Due to the increased risk borne by the factor, non-recourse agreements generally involve higher fees compared to recourse factoring.

Another variation involves how the debtor is informed, categorized as notification or non-notification (confidential) factoring. In notification factoring, the debtor is explicitly informed their invoice has been sold and is instructed to pay the factor directly. This is the more common approach.

In contrast, non-notification factoring means the debtor is not informed their invoice has been sold. The debtor continues to pay the client, who then forwards payments to the factor. This arrangement is less common and often requires stricter client eligibility due to the factor’s reduced control over collection.

How Factoring Costs are Determined

The cost of accounts receivable factoring is determined by a “discount rate” or “factoring fee.” This fee is the factor’s primary charge for purchasing and managing invoices, calculated as a percentage of the invoice’s face value. This rate can be a flat fee per invoice or a tiered rate that increases the longer an invoice remains outstanding.

Several elements influence the discount rate. These include the total volume of invoices factored, the debtors’ creditworthiness, the client’s industry, and whether the agreement is recourse or non-recourse. Non-recourse factoring often carries a higher fee because the factor assumes greater risk.

The “advance rate” also plays a role in the cost structure. This is the percentage of the invoice value the factor pays upfront to the client, typically 80% to 95%. The remaining portion, held back by the factor, is known as the “reserve.” This reserve acts as a buffer against potential disputes or issues until the debtor fully pays the invoice.

Once the factor receives full payment, the reserve is released to the client, minus factoring fees and agreed-upon charges. For example, on a $10,000 invoice with an 85% advance rate and a 2% factoring fee, the client initially receives $8,500. After the debtor pays the factor the full $10,000, the factor remits the remaining $1,300 ($10,000 – $8,500 advance – $200 (2% fee)) to the client. Minor fees may also apply.