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What You Need to Know About Accounts Receivable Factoring

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Accounts receivable factoring is an accounting term that many small business owners may not know about, but that could save them someday.

Depending on the type of business you have, accounts receivable factoring could come in handy if you ever experience a big cash flow problem.

What is accounts receivable factoring?

Simply put, it’s when you sell your accounts receivable to a third party for a percentage of the outstanding balance.

The company may also decide to advance you the outstanding amounts so that you have more cash flow in your business. In this case, it’s referred to as accounts receivable financing.

The third party would then assume responsibility for any risk involved in collecting payments from your customers.

How does accounts receivable factoring work?

Let’s say you have outstanding invoices totaling $20,000 which you need paid in order to make payroll this week.

You would contact an accounts receivable factoring company and sell those invoices. The company would pay a percentage of those invoices upfront.  Keep In mind that you’ll never get 100% because they will take a cut.

From there, the business owner has the money they need to make payroll and the accounts receivable company would take on the responsibility of getting those invoices paid.

[Related: 3 Ways to Stay On Top of Accounts Receivable]

Types of businesses that will benefit from this.

While this service is more readily available to small businesses, the reality is this may not work for every kind of business.

It does, however, work for a few.
For example, if you have a products-based business that relies on physical inventory, using accounts receivable factoring can ensure you have the cash flow to restock.

As we already mentioned, accounts receivable factoring may also help you make payroll if you’re in a bind.

Average cost accounts receivable factoring

By general rule, you will pay a fee between 1% and 5% when using accounts receivable factoring.

If we go back to the $20,000 example, that means you’ll receive anywhere from $19,800 to $19,000 of the outstanding invoices.

If you go the accounts receivable financing route, there may be additional fees and interest.

Additionally, the fee may also vary according to volume, the specific terms of the invoices, which industry you work and more. Some companies also have a set-up fee for first timers.

While it’s a pain to lose money to fees, you could make up for it by taking factoring fees into account in your pricing. You’ll especially want to do this if your payment terms are 60+ days.

When would you need accounts receivable factoring?

There are a few instances in which a business may need to use accounts receivable factoring to free up cash flow.

The first example, which we already mentioned, is to buy inventory.

You may also need this services if you don’t have payment terms that really work for you. This is especially important if you do a lot of B2B work. Sometimes companies have specific rules they want their accounting departments to follow for dispersing payments to vendors.

Lastly, you may need to consider accounts receivable factoring if your clients don’t pay for long stretches a time. The same is true if you find yourself always chasing clients for payments

How to find a good accounts receivable factoring companies?

While accounts receivable factoring is becoming more mainstream for small businesses, they are not all created equal.

Here are some of the things you’ll want to look out for when looking for a reputable accounts receivable factoring company:

  • Quality reviews from customers. Social proof will work too.
  • References from people who have used their services.
  • A good standing with the Better Business Bureau.
  • A good online reputation. In particular, you’ll want to see if they’ve ever had any actions against them.

You’ll also want to look at pricing. While it may not be an indicator of quality, it’s still an important factor to consider. This is especially true if one company charges more fees than the other.

How long does it typically take?

Accounts receivable factoring and accounts receivable factoring allow companies to get capital quickly.

According to Investopedia, companies can get immediate access to cash based on the value of their invoices.

What are the advantages of accounts receivables factoring?

The main advantage is that business owners can get fast access to cash so they can get back to business.
While they won’t get all of the money, they should get enough to keep the business running.

Additionally, businesses won’t have to worry about chasing down those unpaid invoices anymore because the factoring company assumes the responsibility.

This frees up both money and time so business owners can focus on more important things.

What are the disadvantages of accounts receivable factoring?

The main disadvantage is that businesses don’t get the full amount of the invoices. There may also be additional fees.

Furthermore, whether or not a factoring company either buys the invoices or advances them will depend on the value of the invoices themselves. For example, new invoices are seen as more valuable than old ones.

What’s the difference between a small business loan and factoring?

Another way that businesses have typically dealt with cash flow issues is by taking out small business loans.

The problem is unless you’re an established business, these loans are not easy to get. They can also take forever.

Small business loans are based on the credit worthiness of the business owner whereas accounts receivable factoring takes your clients’ creditworthiness into account.

Because of this, it may be easier to use an accounts receivable factoring company than it will be to try to get a small business loan.

This is especially true for less established businesses that have no history with the bank at which they are trying to get the loan from.

Final Thoughts

Small business owners may think they’ll never need accounts receivable factoring, but the reality is they never really know. That’s why it’s important to know how this option works in case they ever run into cash flow issues.

At the end of the day, factoring could make all the difference in making it to the next month.

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Millennial Finance Expert and Writer
Amanda Abella is a Millennial Finance Expert that helps people understand their finances and eliminate all bad debt. She wrote a book, Make Money Your Honey. It is a powerful guide on how to have a better relationship with work and money. You can actually start building an extremely profitable business around the things you’re passionate about.

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