On the surface, factoring and accounts receivable financing may seem to be very similar services. However, under the surface you can get a very different picture. First, the size and strength of the companies qualifying for these services will vary dramatically. Likewise, the size and strength of the companies providing these services is usually very different. In addition, the rates are different, the collateral is different, and perhaps, most of all, the minimum volume required is quite different.
What is Accounts Receivable Financing?
Accounts receivable financing is a very specific type of revolving loan. As a loan, it is the ultimate responsibility of the borrower to pay the lender back in accordance with the terms of the financing contract.
It is also worth noting that the amounts of money obtained through the financing arrangement are recorded on the borrower’s books as a liability until paid back.
Most accounts receivable financing services are performed by banks. There are some thrift and loan companies that are in this business and a small number of independent loan companies that will do it but all companies performing this service have loan licenses.
The reason banks do most of this type of business is they have the resources to make large deals and can give more competitive rates than smaller companies.
How Does Accounts Receivable Financing Work?
Typically, in a bank line or an A/R line (the industry jargon for this type of service) the borrower submits a monthly aging list to the bank and then a percentage, usually about 80%, of the eligible accounts is designated as the maximum amount borrowable for that month.
The borrower handles their own collections and pays down the bank line as needed to stay within the monthly maximums allowed. Additionally, there will be an overall hard maximum identified in the financing contract which will have a term of at least one year.
Ineligible accounts can vary by contract but just to give a few examples: accounts over 90 days old, foreign debtor accounts, or government debtor accounts.
Bank lines will almost always be collateralized by all assets of the borrower. If the borrower is a company, the owner and/or officers of the company will have to guarantee the loan also.
Qualifying for this kind of financing is a purely mathematical function. If you can show net worth in-excess-of the amount to be borrowed, your chances will be good that you will qualify.
Rates are largely mathematical as well. The better you look financially the more secure the bank will be and the better your rate will be.
It should be noted, however that banks are prone to have other charges besides interest. This will vary from one company to the other.
Some examples of ancillary charges include:
- Per invoices charges
- Audit fees
- Credit checking charges
- Unused line charges
All in total of all charges are still usually lower than factoring charges but sometimes not by much.
Logically, big corporations with a lot of net worth are going to gravitate to banks if they need accounts receivable financing. Banks usually will have large minimum volume requirements that only large companies can qualify for. It is not unusual for a factoring company to have an account receivable financing contract with a bank.
What is Invoice Factoring?
Invoice factoring is the sale of an account receivable. Invoice factoring does not involve a loan and the seller does not record a liability on their books.
Instead, they reduce their accounts receivable by the amount of the sale and increase cash by the amount they receive. Factoring is often referred to as “off balance sheet financing” although the word financing is a misnomer.
Factoring companies can be large or small. Many factoring companies do have a loan license, but it is not required. Buying accounts outright instead of loaning against them makes the factoring company responsible for credit and collections on those accounts.
Indirectly, this becomes another service the factor is providing to their clients. Also, the factoring company must employ skilled personnel to manage the accounts of the clients they buy from.
Factoring companies tend to deal with smaller companies that cannot qualify with a bank. Factoring companies are usually more liberal with the amount of money they will give for accounts and rarely pay attention to the net worth of the seller unless there is a tax lien or a bankruptcy.
How Does Invoice Factoring Work?
Factoring clients, or sellers, submit invoices to the factor as they are created from either the delivery of goods or the performance of services to their customers.
The factor usually advances from 80% to 95% of the face amount of the invoices submitted and then notifies the account debtor that the factor now owns that invoice and payment should come to them. Once the factor gets paid, the remainder (the portion that was not originally advanced to the seller) becomes due minus the factoring charge.
Factoring charges are higher than bank financing charges for three primary reasons:
- The size of transactions are smaller
- The administration of the accounts is much greater
- The risk factor is higher
Even so, factors will differentiate their rates based on the merits of each prospective client. For example, invoice volume is a key element.
Factoring companies usually will only claim present and future accounts receivable as collateral against their clients. Factoring clients then have the option to seek additional financing by using equipment or property as collateral.
Both factoring and accounts receivable financing companies serve the same purpose of facilitating growth and expansion for successful companies.
It is frequently the case that a company will begin with factoring and over time and continued growth they will graduate to an accounts receivable financing program.
Less frequently, but still sometimes, a larger company will opt for factoring because it is faster, less encumbrance on their assets, no concentration rules (banks sometimes will place a maximum of 25% of outstanding with any one customer), and the amount of advance is greater with a factor.
While factoring may be the best financing choice for your business, you still need to be sure you choose the right company to work with. Learn how to choose a factoring company here: